Does a rising tide really lift all boats?

If you've been around the investment world for very long, you will no doubt have heard the old adage, "A rising tide lifts all boats."

We've pointed out before that investors should exercise caution when choosing whether or not to accept old investment bromides as being beyond question, such as in our examination of the advice to "Sell in May, then go away."

The expression "A rising tide lifts all boats" is meant to emphasize the primacy of the overall economic environment over the importance of the individual businesses negotiating that environment like so many boats upon the sea. When the tide is rising, according to this axiom, everyone benefits.

There is a degree of truth in this expression, and we do believe that the overall "ocean conditions" are important to the performance of the businesses which must sail through them on a daily basis. We have written about some of the important barometers for measuring the existing conditions many times before, particularly taxes, interest rates, inflation, and global freedom, discussed in last September's post entitled "The Four Pillars."

However, we have also made the observation that -- while "rising tides may lift all boats" during periods of expanding economic freedom (lower taxes, lower inflation, etc.) -- history seems to demonstrate that when the overall situation is less inviting, some boats do much better than others, even during the relative upswings.

For example, we have presented data which illustrates that during the 1970s, the rebound from the crushing bear market of 1973-1974 was extremely lopsided, in which there was a huge performance gap between smaller and more innovative companies and larger and more mature companies. During the "rising tides" of 1975 and 1976, for example, some "boats" did a lot better than others.

In fact, as we pointed out, it was not until the mid-1980s and the decade of the1990s, when conditions improved dramatically in the categories of tax rates, inflation, interest rates, and economic freedom, that large-cap names began to take the lead again. During those years, the rising tides really did lift all boats, to such an extent that many investors came to believe that they should just "own the entire market" (via an index fund or similar investment) rather than trying to search out superior individual businesses for their investment dollars. We pointed out that a similar fallacy had taken hold in the 1960s, in a strategy known as the "Nifty Fifty," but that the 1970s put an end to that strategy, which was also based on a belief in the "rising tide" theory.

Today, many investors and their advisors remain enamored with the idea of "indexing" or owning the entire market. We have expressed many times the reasons why we believe investors are better served by allocating investment capital to growing, well-managed businesses as opposed to focusing on "the market" (or various sectors of "the market"). Beyond that, it is very possible that the conditions that allowed the index theory to arise in previous decades may well be history for the next several years.

While the idea that "we could be entering a period similar to the 1970s" is not a new one, we would actually argue that we may have entered such a period three or more years ago, and that it is hard to say when conditions will get back to the "rising tide" business-friendly scenarios of the 1960s, 1990s, or the second half of the 1980s. During such periods the importance of selecting more innovative companies becomes far more important.

While there is often a substantial grain of truth behind well-worn "market sayings," investors should realize that these adages by their very nature and origin usually focus more on "the market" than on the importance of individual businesses and their specific strengths and weaknesses. We would argue that now is a very good time to be wary of market-focused platitudes and concentrate on finding businesses that are well situated to navigate some potentially stormy conditions.

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For later posts on this same subject, see also: