What Works on Wall Street | Jim O'Shaughnessy | Talks at Google

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👍︎︎ 1 👤︎︎ u/fongstar 📅︎︎ Apr 06 2017 🗫︎ replies
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[MUSIC PLAYING] SPEAKER: Hello and welcome, everyone. Jim O'Shaughnessy is here. He's written this fantastic book that has stayed the test of time through good markets and bad markets. You're a value investor, you're an author par excellence, and we are so glad to have you here to share your experiences with us. Thank you, Jim. JIM O'SHAUGHNESSY: Terrific, thank you. [APPLAUSE] And I'm delighted to be using a Mac because I'm much more familiar with the Mac so that's better for everybody. I like to start these talks with a story that illustrates some of the problems that we face when trying to be good, active investors. And it considers a fellow who dies-- he's an Uber driver-- and he dies in a crackup, goes up to heaven, sees Saint Peter, and goes right past him because he sees Einstein sitting at the center of this huge group of people. And he waddles his way in and Einstein says, "Hi, Albert Einstein-- welcome to heaven. What's your IQ?" And the driver said, you know, I have been trying forever to get a job at Google and, you know, I just can't get in. I've been there three times. I googled the questions they're going to ask me, I think I've got it down-- I know everything about physics, I know everything about electrical engineering, I know everything about computers-- but I just keep failing the questions. And Einstein, yeah, yeah, that can be hard, I know. I watch that group-- they're very, very bright-- I get it. What is your IQ? And the guy goes, well, I don't want to brag or anything but my IQ is 175. And Einstein goes, this is incredible. We'll be able to talk about unified field theory, about string theory, about everything that's been going on in the world of physics since I'd died. Oh, my god, you wait right over there-- I want to get in a conversation with you right away. I want to figure this spooky action at a distance out. Maybe you'll be able to help me out. He points to another guy. He says, hi, Albert Einstein, welcome to heaven. What's your IQ? And the guy goes, well, it's not 175. I guess I'm a bit average, right, so my IQ is about 120. Einstein thinks about this for a minute and he goes, well, OK, OK. Maybe we can talk about what's happening politically down on earth and maybe we can talk about what movies you like. And if you're reading anything, which I probably highly doubt, but if you are reading something I really, really want to hear what you're reading and keep in mind if it's something that is a potboiler, I don't consider that reading. And the guy goes, duly noted. And he kind of walked away dejected because that's really all he had. He points at the next guy and he goes, hi, Albert Einstein, welcome to heaven. What's your IQ? And so the guy looks at him and he goes, I'm not going to tell you. And he goes, come on, come on-- you're in heaven. You're going to have infinite knowledge-- everything that the universe is you are going to know as soon as you stepped through those gates, so it doesn't really matter what your IQ was when you were on earth. The guy pauses, takes a deep breath, and he goes, all right, I make Forrest Gump look like a genius. My IQ is 52. And Einstein says, so, what do you think the market's going to do tomorrow? [LAUGHTER] I think that we all too often feel like Forrest might have a better answer than we do, so I wrote a paper recently about why it is so hard to be an active investor and what I want to talk to you today is about that. We've all seen the herd mentality move many, many people to passive indexes. I would remind you that things like the S&P 500 are strategies, right? The strategy there is buy big stocks-- single-line strategy. Globally, it's buy these global big stocks based on their market capitalization. Through the research that I and my team have conducted, we have found that there are very many other factors that work significantly better than buy big stocks. The challenge that we face there however is, by definition, our portfolios are very different than the benchmark if the benchmark is the S&P 500. And the first thing that we really want to think about is passive investors-- they face one point of failure, right-- presuming they're well diversified, et cetera. The only point of failure that an active investor faces is panicking near a market bottom and selling out of all of his or her index funds, OK? That's really the only thing they have to worry about because, by definition, they're getting the average return, they're getting the low costs-- they're getting a lot of really good things. But they do face that point of failure and, sadly, I have seen many, many people who swore that they would never ever do such a thing do exactly that. But us poor hapless active investors face two points of failure. The first is the same as the index investor, right? We panic and we sell out before or near the bottom of a market-- but the second one is really more insidious. The second point of failure that we face is we suddenly are comparing our returns of our investment strategy or our ETF or our mutual fund with its benchmark, right? Everything has a benchmark and if you're a value investor and it's a large cap strategy, your benchmark is the Russell 1000 Value Index. If you're a small cap value, it's the Small-Cap Russell Value Index. And we compare these things constantly and what I have witnessed over my entire career is that really human behavior never changes-- we're going to get back to that in a minute. But typically what happens is that people mismatch their time frames, right? So the majority of people who are actually making decisions on whether they're going to stick to an active strategy are using possibly the worst time frame to look at and that is three years. I won't bore you with a lot of people that I know who do it on a quarterly basis, but what I can tell you is that if you do this on a quarterly basis, I will guarantee that you will fail because quarterly data-- there is no signal, it is all noise. And because of the nature of human beings, we always will clamp a narrative around anything that we see and the narrative is going to sound really interesting. You're going to watch CNBC and you're going to hear some guy say, well, this quarter happened because of x, y, and z. Well, let me be the one to tell you-- having been on CNBC a lot-- he is absolutely full of it. He thought about that on the way over there, honestly, because he has no idea why the quarter did what it did-- no one does. And so when we accept that fact and start trying to look at longer periods of time, we're much, much better off. But three years-- absolutely one of the worst things that you could look at. As a matter of fact, a friend of mine Josh Brown, who blogs at a site called The Reformed Broker, found a really neat study. And this study basically showed that investors who fired an active manager for under-performance and hired somebody else-- guess what happens? The manager they fired goes on to do vastly better than the manager they hired. I'm sure many of you are engineers, so you understand the concept of reversion to the mean. They had a bad three-year period generally-- not always-- but generally followed by a good 3-year period. The manager that was hired, well, guess what? They're coming off a great 3-year period and we love those numbers. We just love seeing them beat that benchmark and yet we really don't know why they might have done it. Two stories that I think are interesting that will help us understand why the long term is against us. The first is human nature-- we are very temporal creatures and there is a bias in behavioral finance called the recency bias and we are all subject to it. Everyone in this room, everyone on this campus, everyone in the state, in this country. Recency bias simply says we pay the greatest attention to what has happened recently and then, to compound our error, we forecast whatever has been happening recently into the future-- a very, very bad mistake to make. So I'll tell you about something I did that demonstrated recency bias. So when I was a young guy and beginning to look into why stocks did what they did and a big believer in factors-- underlying things like PE ratios, dividend yields, et cetera-- I had a cousin, Jerry, who is a true wild man. And he had called me on the phone and he goes, Jim, you've got to get into this stock. This thing is going to explode, it's going to get taken over, this is my industry, I know it-- this is fantastic. So what did I do? I bought it-- of course, I bought it. And I looked it up in the newspaper every day and I was a little put off by the fact that rather than going up and up and up, it went down and down and down. So I kept calling, Jerry-- Jerry, what's going on? You told me? Don't worry about it. They delayed the announcement. It's going to come out, just keep on buying-- buy it, buy it. You can't lose. Any time you hear the term you can't lose, I can tell you, you will lose, so I did. And sure enough, as you probably can anticipate, the stock cratered-- it did horribly. Why? Because I telescoped my feelings into the here and now and when we do that, we are inordinately made to think only of the here and now. And smartphones aren't helping us, right? So I'm glad I don't see too many people on their smartphone, but it is reducing our attention span from quarters to quarter of seconds, right? And so very, very difficult to think differently. The other story, which is kind of a sad story-- at least for the guy, not for his kids-- was I had a good friend and this guy is super smart. I don't know if he was smart enough to work at Google, but he was very good in real estate, switched on, knew everything about everything-- just a really, really, really smart guy. And so it occurred that he became our contrary indicator. In other words, whenever Art called me on the phone and said Jim, put me all in. Put me all in your most aggressive strategy. I would say, are you sure you want to do that because, what had happened? Obviously, it had done really well over the past year or two. And yep, you got to do it. You got to do it for me. And I went, OK, will do. Hang up the phone, get on the speaker that everyone at the firm working for me at the time can hear, and I said, we've just called a market top. And it virtually always worked. Of course, he did the same thing on the way out. Get the call from Art, "Jim, sell me out of everything. This market looks horrible." And he'd enumerate all sorts of reasons why, and I'm like, "Art, you realize that you really don't want to do this. You really should be buying now, not selling." "No, Jim. No, no, I know-- I'm selling." Get back on the box, the market has bottomed. And here's what's cool. He had his kids invested in exactly the same strategy that he used. And guess what? He didn't touch their investments, right. It was only his own position that he felt comfortable playing with. Well five, seven years later, Art found that his kids were much richer than Art because they just did nothing. They simply stayed in the strategy and let it do its work. And, so that is kind of in a nutshell what we're facing. And I mentioned recency bias. So, recency bias is really interesting-- you're going to have to unlock this again for me. Recency bias is interesting because it really infects everything that we do. I'll give you two examples. So the first example, let's say you have a doctor and he's been reading the docs on a particular medicine that he wants to use. And he's looking at it, and basically the efficacy is 50/50. You're flipping a coin. And so he decides he likes some of the way it's done, and so he tries it on a patient. And, wonder of wonders, that patient does really, really well. How do you think the doctor interacts with the next patient with the same disease? He says, I want to try this on you, the 50/50 flip. And how does he get the guy to do it? He says, it's working really well with the last guy I tried it on. He totally ignores all of the descriptive data saying this is a coin toss. And yet everybody he says that to says, great, I want to use that medicine. A second one is more market-oriented and it is basically the Bloomberg surveys that they do of investors. Well, you can see this one coming a mile away. When are they absolutely at their most bullish? Well, the last extremes that we noted were in the dot-com bubble. The vast majority of every investor that they talked to and surveyed-- wildly, crazy bullish on the market. When was the lowest amount of bullishness in the market? Near the bottoms of the financial crisis. And what's interesting is we can't help ourselves. So when our ancient ancestors were on that plain in Africa and the bush was rattling, one of them ran away, the other one went, oh I wonder what's in that bush. Guess whose genes got passed down to us? The guy who ran away. So the idea that flee-- let's get out of here-- came down us through our genetic inheritance, and it is very, very difficult to overcome. There's actually a pair of Swedish scientists who did a report-- and I can make all these links available to you if you're interested in reading the source material-- and what they did was pretty clever. They took identical twins, so 100% genes matched. And they looked at their investment techniques, and what they found was really, really disconcerting. Basically in their paper they claimed that 45% of all of the investment choices that we make are genetic and can not be educated against. Think about that for a minute. 45% genetic, education has no effect on that. I often wonder-- because I'm Spock, right, I'm not Captain Kirk-- but it's like, why don't people pay attention? We've had all this data forever and ever and ever. And that kind of turned the light on for me. And I said, oh, I realize why we don't. We don't because we are in an environment where our very genes are rebelling against us and letting things like recency bias and availability bias-- I love that one. Availability bias is how easy do we remember something. So if we're watching the TV news and a terrorist attack happens, guess what we get afraid of? We get afraid that we're going to die in a terrorist attack, even though if you look statistically the chances of that happening are virtually nonexistent. So a good long-term performance-- you know, Cliff Asness who runs AQR-- had a great quote, which was, "If you can have and really live by a good long-term investment outlook, that is as close to an investment superpower as you will ever be able to achieve." And the fact is, the stats show virtually no one can do that. So problem number one. Problem number two is, again, us. The next thing that we focus on when you want to be a good investor is, good investors value process over outcome. What does that mean? Deming had a great quote which was, "If you cannot describe what you do as a process, you don't know what you are doing." So basically, if you're a good active investor, you will always value the process over the outcome. Why is that? Well, because if you know nothing about a process and you're just looking at two numbers, you're basing your decision on outcome. Like right here. This is the five-year result of buying the 50 stocks with the best sales gain-- annual sales gains. And if we were looking at this just in isolation, we'd say, wow, simple strategy, makes a good deal of sense to me. I'm going to do that. This strategy outperformed the S&P 500 in four of the five years that we're looking at here, and it doubled the total return of the S&P 500. Right, so you'd think, if I'm looking at that outcome, I love it. And keep in mind, it would not appear to you in a vacuum. Morningstar would have a five star rating on this fund. CNBC would have this manager on and talking about why this is such a great strategy. "Forbes, "Fortune," "Wall Street Journal," "Barron's" would all be writing glowing stories about this guy or gal. They would say they've got the keys to the kingdom there. This is amazing. OK, this is what happens when you value outcome over process. Let's go to the next slide and see what really happens here. Well, what really happens here is you're wiped out. This is the data between 1964 and 2009. Over to the left is that very same strategy. That strategy did vastly worse than T-bills. Everything else killed it. So let's all imagine that there is a bar graph there for the S&P 500 that says you put your money there, you got $640,000. And all stocks doesn't even have a number but it's better than the S&P 500. The point is a pretty simple one. If you have access to the long-term data, you're going to get much better information about whether the process that you're looking at actually makes sense. For the most part, they don't. Like buying the stock with the 50 highest sales-- oh, by the way, these numbers are from 1964 to 1968. People who don't understand market history it's like Twain said, history doesn't repeat itself, but it rhymes, right. So in 1964 to 1968 we had a bubble just like the dot-com bubble, and it led to all sorts of things that we don't have time to get into. But in terms of practical human nature, they behaved exactly the same then as they did in the dot-com bubble. And then for people who don't like the idea of-- well, '60s, that's meaningless-- this same strategy for the three years ending February of 2000 compounded at 66% per year for the prior three years as of February 2000. Boy, that's really difficult to ignore. And the only way you can ignore it is if you look at the much, much longer term in terms of the underlying strategy and how it performs. When you value process over outcome what becomes important to you is to study as much data as you have available to you to see how things in general turn out. You're not always going to be right. So, one of the reasons why that strategy does very poorly is because, guess what happens. Everyone buys those stocks and they become enormously expensive. They're priced to perfection, and they don't achieve it. So Murphy would be good here. Murphy was an optimist. If it can go wrong, it will go wrong and generally does. What we've found in doing this study is that when you pay for the most expensive stocks you manage to subtract about 6.2% from the return from the index. Think about it like it was a lemonade stand. If there was a-- or you showed me the trucks. OK, so if one of these trucks was out there, right, and you were getting your lunch and you're talking to the guy and the guy says, hey, truck's for sale. You're like, cool. I like this food, I like everything about it. What are your revenues? And the guy goes, yeah, the revenues are about $100,000 a year. OK, that's pretty cool. What do I have to pay you to buy your truck? Yeah, I'm going to need $10 million. And you're going to look at him, and you're going to go, well, OK, I didn't realize that you were insane. I guess there's a correlation between insanity and making good gyros, I don't know. But in a specific example like that everyone goes, oh yeah, I would never in a million years be willing to do that. Well, take a look around you today at some of the valuations of some of our favorite stocks, and they are in the stratosphere. We call them lottery stocks, right, because when you look at how they pay off, very few of them actually pay off. Like Google-- ooh, paid off. Amazon-- paid off. All of those other 1,000-- you know, Ask Jeeves didn't pay off. Many of the other search engines that were there-- I'm 56, so I used them all-- and Ask Jeeves was really weird, because there was a butler. You're probably all too young to know this, but it was a butler and just made you feel very weird. Hi, Jeeves, can you tell me what's good tonight, and then you'd get horrible results. [LAUGHTER] Good in what way? It's like Kramer when he did the movie phone, right. Why don't you just tell me what movie you want to see? So anyway, what happens happens in tech the same way it happened in cars. At the turn of the century, there were 200 automakers-- 200. Flash forward a couple of decades, there were three. Because what happened was the three winners took it all and everybody else went out of business. And so, when you're paying very, very rich multiples, it really helps to have information like this. The second thing that's really important here-- and we're going to get to it and spend more time on it in a minute-- but is this idea of a base rate. What's a base rate? Real simple, batting average. How often does this particular strategy beat its benchmark and by how much? So in the case of-- this is our value composite which uses five separate value factors-- in the case here, we see that in any three-year period we have a 73% chance historically of doing better than the benchmark. Now what does that mean? It means that we know going in that in every 10-year period we're going to underperform three of those years. So we take a very, much more clinical, if you will, aspect to the way we choose to invest in that we go in accepting the fact that we're going to fail and knowing by about how much. But to get odds like these on your side is very exciting. And yet people refuse to pay attention to base rates. Here's a great story-- and I, sort of being very logical and rational, I just can't figure out why people won't do this, but they don't-- and it concerns a town-- it's 100,000 in the town. 70,000 are lawyers, 30,000 are engineers. When you just give no information at all, right, and you have a person pick 10 names out of a barrel and you say, OK, how many are lawyers and how many are engineers? Everybody guesses the same way. They say well I'm going to say they're all lawyers. That way I'm going to get at least seven right. And they've done this experiment. This one was reproducible. They've done this a number of times, always comes out the same. So they pay attention to the base rate. Next, they add meaningless descriptive information. Tom is 33 years old, wears glasses, and likes to ride his bike to work. People start thinking, huh, I can't see a lawyer wanting to ride his bike to work. I know that I shouldn't, but I'm going to say that he is an engineer. And they basically, just on meaningless information, allow huge mistakes to start entering their forecast. Then finally, they give stereotypical information. Frank is 34 years old, shy, likes mathematical puzzles, spends weekends on his computer, and really, really hates parties. And so, everyone says, I don't care if it's said that there were 99,000 lawyers and 1,000 engineers, this guy is an engineer. No he wasn't. He was a lawyer, because the base rate said that that's what he had to be. So, base rate information is vital when you're trying to manage money effectively over long periods of time. Another thing that-- I love this quote-- another thing that successful active managers don't pay any attention to are forecasts. And it's really interesting to me because that's all we crave. I was on Twitter before I got here, and it was always-- everyone is, so and so is saying that fill in the blank. The market's going to collapse. The market's going to soar. This stock's going to do well. This stock's going to do poorly. Fact of the matter is they have zero-- zero-- effort at getting a correct forecast. Forecast, the old maxim was forecast early and forecast often right because you're always going to probably get it really, really wrong. What we do when we're looking at forecasts is we get sucked in to the story of the forecast. And I even find myself-- like, I was on CNBC one day and this guy he had a great story, right. He's like, well we've looked at 110 different variables and we ran a correlation matrix about how these variables have done in the past, and I'm very confident to be able to tell you that sometime this week the market is going to go down by 10%. And I really had to kind of leave, go to the green room, throw water in my face, and-- He has no idea what he's talking about, and yet we love it right because we crave narrative. We want to know the future, right. And I joked the other day that, I will predict that in the future people in the future will think they can forecast the future. And Cicero, a Greek philosopher and statesman who didn't end well, had a great quote that went along the lines of, you know, it doesn't matter how learned you are or how base. All of us believe that we can forecast the future, and we can't. And it would be great. and if I could forecast the future, I can promise you I would not be standing here giving this talk to Google. I would be on my own private island, having flown there in a G5 because I would've done just great. And the fact is, though, it is our very human nature that makes us want to be able to make those types of forecasts. Here's a forecast. This is kind of interesting. So, CXO is a site that is dedicated to what we do, investing. And over a long period of time they gathered 6,582 forecasts, and down here are the results. So basically, these-- now remember, these weren't people they pulled off the street, right, hey what do you think the Dow's going to do? Actually, there is a thing called the wisdom of crowds that say you might do better if you pulled enough people off the street. That's a different story. Anyway, these experts-- 42 of these experts had efficacy ratings below 50%. What does that tell us? We get a room full of monkeys. We give them quarters. We have them flip those quarters. And we're going to do better on our forecast than these so-called vaunted experts. I mean, let that sink in. And again, we can't help ourselves. There's this thing called the halo effect. The halo effect is-- well, you guys all have the halo effect. You work at Google. I mean, how cool is that. And so what happens is-- oh, you work at Google-- immediately that person begins to attribute to you all sorts of things that many of you don't deserve, right. It's like, yeah, yeah I work at Google, how you doin'? And suddenly, that other person who is meeting you for the first time is enraptured. You're smart. You're good looking. You work at Google. Oh my god, this guy is amazing-- happens in what I do. It happens everywhere, right. The minute you get published in a prestigious journal or the minute you come up with a great algorithm you get other attributes assigned to you that you don't deserve as the cold hard facts basically point out. And so-- it's not just this, by the way. They used to do surveys until they got so embarrassed by them that they stopped doing them. And these were surveys of institutional investors, and they did them once a year because they had a big gathering in New York City. What's your favorite stock for the year? Well, if you-- Jim Chanos, who's very famous for shorting stocks. I gotta bet that he was simply there writing them down and then running out and shorting them. 1999, Guess what their favorite stock was. Enron. They loved Enron. And for those of you unfamiliar with Enron, it was the largest bankruptcy in US history at the time. They were lying to everybody. And again, showing the importance of narrative, I talked to a fund manager who owned Enron, and he was telling me he was buying more. I'm like, dude-- we showed him the quants screens-- and it's like, this is not a stock you want to buy. It's in the worst category on financial strength. It's in the worst category on value. It's in the worst-- essentially, it's like the worst stock. And he's like, no, no, Jim, you don't get it. I got invited to a barbecue at the CFO's house-- of Enron. The CEO was there. The chief legal counsel was there. Everybody was there. And they gave me a beer and we started talking, and they assured me-- they assured me-- that their stock was going to double from these levels. And I'm like, OK, probably a really good thing you didn't go to a barbecue at Bernie Madoff's house because he probably would have even given you much better assurances as to the efficacy of his particular take. And yet again, we're coming back to the theme here, which is guess who sits right at the center of all our screw ups. Us. It is human nature to do all of these things because a lot of shortcuts work. A lot of them don't, right. So recency bias doesn't work when you're trying to think long term. Availability bias narrows you down to thinking about just what you can remember. You know, overconfidence bias-- I'm sure that many in the room have that. I certainly do. Overconfidence bias is, hey, I'm a stud. I know how to pick stocks. This is great. No I'm not, and the fact is I make as many mistakes if I'm trying to do it without the guidance of base rates and all the things that we've been talking about as anyone else. And so, in terms of predictions, the last story will tell, which I love. So "Fortune" magazine, in its wisdom, decided to do a cover story in the summer of 2000, and the title of this story was "10 Stocks for the Next Decade." And they hyped it, and they-- these are going to be the best stocks. Buy these 10 stocks. Don't even look at your portfolio over the next 10 years. You're going to be delighted. Well, for people who actually didn't look at their portfolio it did probably save them from killing themselves because, of the 10, two went bankrupt-- Enron we've already mentioned, and Nortel, the big Canadian name. And the balance of return for these 10 stocks was minus 27% overall versus a gain of 116% for the S&P 500. Why? Because they got caught up. They love this story, and they just couldn't-- they just couldn't bring themselves to think not in terms of stories, but in terms of what's going on right then and there. The next thing I'd like to talk about is-- to be a good active investor requires patience and persistence, and most of us are not genetically designed to do this. We want results now, right. We want the win. We want to be able to look up at the monitor and see, wow, it's up half a point since I bought it. I love it. This is great. And yet, we really need to let these things play out over longer periods of time. Now, I happen to be highlighting Warren Buffett here, but this is the same for anyone you've heard of-- guys like John Neff, Peter Lynch, etc. Actually, Joel who spoke here yesterday is also on this list of a great investor. And the fact is they got there by being patient and persistent So, Buffett we can see how well he did in all rolling one, three, five, seven, ten-year periods. And when we look at one year, pretty high, 73%, not bad. But that means that in any three of those 10-year periods he was doing very badly. And he was doing really badly during the dot-com bubble. And I recall that virtually every story I read about Warren Buffett was, man, great guy, used to have the chops. He's just too old. He's too old. Do you know that he doesn't use email? He writes it out longhand and his assistant emails it. I mean, come on. This guy just-- he doesn't get it. And you listen to people talking about him on CNBC, same thing. Yeah, he had a great run, but we got a brand new economy. He's a relic. This guy just can't do it anymore. Did Buffett change anything that he did? Absolutely not. He was patient. He was persistent. And he has a very well-known-- if you read any of the books about him-- group of things that he looks for, and these are some of them up there. And yet look at his 10-year win rate. 100%. You don't see too many 100% 10-year rates. How did he achieve that? By paying zero attention to all of the noise, all of the people calling him out, all of the people calling him names, making fun of him. All of that was happening around that time. And he just stuck to his game because he knew that game, and he knew what his base rates were. He knew what his level of success was. The same thing happened to all those other active managers I mentioned. So, if you're an active manager, if you want to do it on your own, you've got to get ready for the idea that there is going to come a point in time where you look really stupid. I say to my wife, who is nice enough to come today, more for the tour of Google than to hear me-- because, as she said to me earlier, you're such a gas bag I hear all of this anyway. I don't need to be here But, here's the path of an active investor-- hero, goat, hero, goat, hero, goat. If you don't have the constitution to make that work for you, it's going to be very difficult, and we're going to come to that point in a minute. So I love this quote, too. Charlie Munger, "You don't want to believe in luck. You want to believe in odds." I think this is one of the more important things that I want to tell you about because we live in a world where people believe more in possibilities than they believe in probabilities, as crazy as that sounds. What's possible? OK, what's possible? I flew out of JFK to come here, very possible my plane crashes. Very possible that I make it on the plane, but then the Uber driver gets into an accident and I get killed. Very possible that somebody decides they're going to mug us when we're walking to dinner. Very possible that all these horrible things could happen to me. Well people who think in terms of possibilities, what are they going to do? They're never getting out of bed, right. It's like the only good thing that could potentially happen to them is they could win the lottery. And as Fran Lebowitz loves to say, your chance of winning the lottery or not is the same whether you buy a ticket or not. So that's the good thing. Everything else is bad, right. Remember the movie "Dumb and Dumber," and Lloyd Christmas had the hots for the woman who he rescued, and he says to her very hopefully, you know, Mary, I just got to know. You just got to tell me. Do I have a chance with you? Of course she's happily married, can hardly wait to get back to her husband. And she goes, I don't think it's looking very good for you, Lloyd. And he goes, well, so give me the odds. Give me the odds. And Mary says, I'd say the best odds that you're going to see are one in a million. And Lloyd gets this huge smile on his face, and he goes, "so you're telling me I got a chance!" [LAUGHTER] No you don't, Lloyd. You're not hooking up with Mary, and you're thinking about possibilities not probabilities. Now, some real world examples. People who think in terms of possibilities, they freak out, right. It's the bottom of the financial crisis and I'm going down to Washington to call on one of the smartest, most articulate advisers we'd worked with. He'd been a client for 10 years. I get there with my head of private client services. We walk into his office. Literally-- this is the door. We get here, one foot in. And he's like, stop right there. Stop. He's sitting at his desk. So Ari and I look at each other like, OK, are you scanning us for weapons? What's going on? And he goes-- puts a hand up like this, O'Shaughnessy, I know what you're going to do. I know that you're going to show me all sorts of charts and graphs and you're going to show me that thing I just saw on your website where you looked at the 50 worst 10-year periods back to 1871 and how in every one of them the next three, five, seven, and ten years were very, very positive-- talk about having the odds on your side-- and I know you're going to do this, and I don't care. I have to act right now on what's happening right now because you say it's a possibility, I say it's a probability. The US is going down. And I was like, well, thanks for keeping the meeting short. Good luck with your gold and your cave stacked with antibiotics and weapons. Can I get the address of that just in case? Anyway, he went on to do very poorly, obviously, because we published this piece in March of 2009 saying a generational buying opportunity. I heard crickets and/or you're crazy, you're a mad Irishman, et cetera. And so, what we found was people understood what we were trying to tell them, but they just didn't want to listen to it. And this is endemic across the spectrum. There was a great story about a guy by the name of Semmelweis. He was a doctor in Vienna in 1847. And he was assigned to the maternity ward, and he noticed that the women who were being delivered by male surgeons were dying at a rate that was five times the rate of those that were dying serviced by midwives. He was like, hmm, this is bad. And so, he was a scientist. Let's test a hypothesis. Well, the women who were attended by men are on their backs. The women who are attended by women are on their sides. Let's put everybody on their side. No difference. OK, well, we have this really creepy custom of if somebody dies a nun goes down the row of beds with the women ringing the death bell. Yep, another one bought the dust. You're probably next. So he had them stop the death bell. No difference. And then he said, I think it's that we aren't washing our hands. And so he had a special concoction of lye and several other things that he forced the doctors-- he was the chief guy-- forced the doctors to wash their hands. Death rates plummet, his Eureka moment, OK. It's because you're going from dissecting cadavers to giving birth. You're passing along some pretty nasty stuff. Everybody's got to wash their hands. And so they did, begrudgingly, because again society. Society is our software, right, and it's evolved rapidly. Our hardware has not evolved at all. So we're running 21st-century software on a 50,000-year-old hardware. And this is where we run into all of our problems-- because society was going to reject. Semmelweis. The men didn't like having to wash their hands, and they stopped. And they kicked Semmelweis out. He ended up, unfortunately, in an insane asylum where he died of the exact same disease that all of the women were dying from, sepsis. And it took another 50 years before some other doctors said, hey what's this hand-washing stuff? And so, all of that time, they weren't looking at the probabilities of his example. They were looking at the mores of the particular time in which they lived. So, when you're looking at probabilities, what you want to see is lots of data, right. So, here, shareholder yield-- I won't spend a lot of time on this, but shareholder yield means you buy the stocks that have the highest buyback rate and the highest dividend yield. And we actually have this data going back to 1927. We've truncated it here for ease of looking at it. But look at its base rates. It's amazing. And when you think about it, and you dig deeper, you say, OK, this is how it's done on all rolling five-year bases. Wow. The probabilities that I've got here are really in my favor. Now, you can see underneath-- not all the time, right. So, there are going to come times when we have to suffer a bit, but the preponderance of the evidence basically says this is a great way to buy stocks. The point of this is quite simple. Diluters-- you, know Snapchat, right. They're diluting the hell out of their owners by issuing new shares-- typically lose the most money. Expansion loses almost the same amount of money as the diluters. The only one that actually makes a ton of money are buybacks and dividends, returning capital to the shareholder. Everything we've talked about right now is absolutely meaningless unless you as an investor, if you're doing it yourself, or the person that you hire to do it for you, has unwavering discipline. And I got to tell you, having been there many, many times, this is really easy to say, and it is really, really hard to do. When things are going your way, you are the cock of the walk. You're, of course, it's 500 basis points of its benchmark. We've got the greatest strategies in the world. And you're feeling so good that if you had a song the lyrics would be, or the title would be, the future's so bright I gotta wear shades, right? I mean, you're loving life. But as is the case in all active managers, the one thing I can tell you is you are going to underperform. Sometimes by a lot. That's when you have to have discipline. So, how many of you sold a stock that you bought on a tip and it did horribly for you? Actually bought that stock on a tip. How many of you-- you can just keep your hand up. How many of you have done something because all your friends were doing it? How many of you watch somebody on CNBC or Fox Business News or any Bloomberg Business News and bought it simply because that man or woman said it was going to be great? And the results, generally speaking, are very, very poor. It's a very undisciplined way to approach investing in the stock market, and it leads to very, very similar results. So, without discipline, everything I've talked about, meaningless, right. And we had a consultant come in and talk to us about what happened with quantitative investors like us during the financial crisis. 60% left their models. More than half left their models, which to me says, every bit of their past performance-- meaningless. Because they didn't have what it took to actually stick to the model. And let me tell you, it's really, really easy to say your disciplined, and doing it is virtually impossible. So if we're going back to songs, your song when you're in your third month of underperformance and everybody's laughing at you, or they're making fun of you on-- you go and do a guest interview on CNBC, and they're just chuckling, are you wrong. And again, recency, right. It's all what's happening right now, not-- long-term track record, meaningless. Right now you're doing horribly, and therefore you are a fool and a buffoon, and do you have a reply Kind of like, when did you stop beating your spouse? And there you are in a dark place. There's just no question about it. You know, Shakespeare had a great sonnet, the 29th, which went, "When in disgrace with fortune and men's eyes, I all alone beweep my outcast state, and trouble deaf heaven with my bootless cries, and look upon myself and curse my fate." OK, if you're reading Shakespeare and you're reciting that particular line from the sonnet, you are near the end. And the fact is that the only thing you have to hang onto is this too shall pass. And it's really not a lot to hang onto. And yet if you don't have that underlying discipline you are lost. And this is sort of interesting-- and we'll close and then take questions. I like this. I love these magazine articles. There's always the five or 10-- only, these are the only things that everybody shares. You know, these are the only ways to get dates. These are the only ways to become a millionaire. There are a lot more. But anyway, for what it's worth, the only five fears we all share. And I want to talk about the last three. Loss of autonomy-- basically, that means that you find yourself in a situation that is entirely beyond your control, and that does not feel good. And you have people coming at you from all sides, and you are getting bombarded daily. You feel like you've lost all sense of control-- very, very tough to gut that one out. Separation-- that's losing people, people rejecting you, people not respecting you for your ideas, and for what you're thinking about. Very, very difficult. And ego death-- I love ego death. Ego death is what it implies. Your self-constructed image of yourself is shattered. It's shattered. Because, if you're an active money manager and you're self-constructed self view is that you're really good at this, and suddenly for months and then maybe quarters and then maybe years all the evidence is saying you're not so good. That takes a toll which very, very few people can actually continue to stick with their underlying strategy. So, I didn't really mean this to be as bleak a talk-- as I'm listening to myself, everyone in here is like, I'm indexing. Jeez. But the fact is, the more people index, the better for me because stocks will become less and less well-priced, right, because they are going into an index. Really, the S&P 500-- it's a momentum fund. When was energy at the top, most overrepresented in the S&P 500? Right before oil collapses. When was tech overrepresented in the S&P? Right before tech collapses. So, nothing's perfect. But the fact is that, in the world we find ourselves in today, the group of active investors while getting smaller and smaller is also becoming a much more effective, in my opinion, club. And if you can weather these things, the amount of excess return over long periods of time that you are able to generate will be absolutely worth having to make it through all of these hurdles, sort of the challenges of Hercules. So thank you, and we'll take any questions. SPEAKER: Thank you, Jim. JIM O'SHAUGHNESSY: Thank you. SPEAKER: Thank you very much. Very provocative, and I expected nothing less. We have room for maybe a couple of questions I want to start with one because you mentioned Warren Buffett in there. Having read some of your works, if one buys stocks in a basket of low valuations-- low price to book, low price to cash flow, that's sort of one we of investing, if you will. Whereas a lot of people who are following, as they say, Warren Buffett, would say his way of portfolio construction is concentration. Six to eight stocks, compounders, hold them for the long term. I would love your thoughts on the concentration aspect, portfolio allocation aspect. And you know, Dogs of the Dow strategy, for example, which you elaborated. You rotate once every year, whereas that other way is hold six to eight for the long term. JIM O'SHAUGHNESSY: Sure, thank you. So, as far as the concentration goes, we believe in highly-concentrated portfolios. We don't own just eight names, but for an active manager our portfolios are highly concentrated. SPEAKER: Could you define, maybe quantify how much? JIM O'SHAUGHNESSY: So in the large cap portfolio we might own as few as 75, 50 to 75 names. And we rebalance these monthly, so the weight of the evidence, right. So if the same name appears each time it gets a much bigger weighting in the portfolio. So, we think that to succeed you've got to be very different than the index so you have to have what they call a high active share, and you have to be concentrated, and you have to have the courage of your convictions. I think most of the managers, maybe with the exception of Peter Lynch, you will see that these are highly-concentrated managers. And that is so because that's where the returns are. It's important to us that you know what stocks you don't own are just as important as which ones you do. So we'll run screens and eliminate half the universe just because they don't qualify. So, yes, a highly-concentrated portfolio tends to lead to the best results, but-- very important caveat-- it can also lead to the worst results over a short period of time. If you're in the group that wants to achieve that long-term excess return, you've got to take the good with the bad. And again it comes back to discipline. It comes back to the things I've talked about-- very difficult, because when your ego is being crushed and your sense of self is gone-- you know, you're not a fun guy at the party. AUDIENCE: So there was a famous bet going on with Warren Buffett and some other hedge fund managers. They bet for 10 years against some index fund, and so it looks like the hedge fund manager's going to lose. So do you think of a reason why they lose? JIM O'SHAUGHNESSY: Sure. So Ted Seides, who I know very well, is the author of that bet, and he took a group of, kind of fund of funds. And I can tell you pretty much very easily why he lost. He lost because the costs of the hedge funds, two and 20, wiped out the advantage that they might have had through performance because Buffett took Bogle and we're talking six basis points. And the second reason was because we had a nine-year bull market starting in 2009, basically continuing to today. And in a bull market, people who are shorting stocks tend not to do nearly as well. And then finally, I think that the hedge funds that Ted picked-- you know, I probably would have taken the index with all of the various hedge funds. But some did really great, and some did very poorly. And the only other thing if I were in Ted's shoes was that if you look at it on a risk-adjusted basis, the so-called Sharpe ratio, actually the hedge funds killed it. They did so well in terms of drawdown versus the index itself, which had a massive drawdown between '08 and '09. And that gets back to the emotional side of investing. What good is an investment that no one can stick at? Yeah, technically the S&P won, but it lost all of its investors in '08 and '09, whereas the hedge funds have lost many of their investors at all because their drawdown was much smaller than the drawdown for the S&P 500. But fair is fair. Ted owes Warren the donation. The thing I found really funny was the thing that they use as collateral, which was zero coupon bonds, beat both. So next time I'm going with the collateral. SPEAKER: I think what they did was they took the zero coupon bonds I think five or six years after the bet and then put them into Berkshire shares. JIM O'SHAUGHNESSY: Right. SPEAKER: So the charity is actually going to get the best of both worlds. JIM O'SHAUGHNESSY: Yes SPEAKER: Gets the bond returns when they did the best and then the Berkshire returns. So this is a very, very provocative note, and we've run out of time. Thank you so much for this fascinating talk. JIM O'SHAUGHNESSY: Thank you very much. Thank you. [APPLAUSE]
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Channel: Talks at Google
Views: 108,021
Rating: 4.8430867 out of 5
Keywords: talks at google, ted talks, inspirational talks, educational talks, What Works on Wall Street, Jim O'Shaughnessy, jim o'shaughnessy what works on wall street, jim o'shaughnessy prime ammo, investing, stocks
Id: w9x09O-csEY
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Length: 63min 13sec (3793 seconds)
Published: Wed Apr 05 2017
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