It's a new year, and portfolio managers everywhere are reviewing their numbers from calendar year 2010 and looking ahead to 2011, which is off to a roaring start in its first day of trading.
The financial media is busy covering equity managers who beat the market in 2011, and investors and their advisors are dumping managers who did poorly to move their money over to those who did well.
While we ourselves had a third year in a row of solid outperformance from the equities of the companies we own (validating the principles we espouse in this blog of conducting fundamental research on the business prospects and management ability of companies), we would like to point out that the focus on the calendar year is an arbitrary measurement, and one that can easily lead investors astray.
We also believe it is important to point out that (as we have said before in whitepapers such as "What hasty investors could learn from an Ent") investors should have a long perspective, because what really matters to most investors is performance over many years and even decades.
The way that investing works, those investors who outperform over long periods of time will always have shorter periods within which they do not perform as well and actually underperform the broader market.
We believe this is because it sometimes takes several years for a company's business prospects to become realized within the business landscape -- often, a company must build towards a change that is underway but has not actually taken place, akin to Wayne Gretzky's famous line about "skating to where the puck is going to be." Because of this fact of business reality, investors in those companies that are "skating to where the puck is going to be" must often endure periods when the stocks of those companies are out of favor on Wall Street and when the "hot money" is chasing something else, creating intermediate periods when their investments do not do as well.
In fact, extensive research bears out the fact that almost all managers who outperformed their benchmark over ten-year periods endured at least three consecutive years of relative underperformance within that ten-year period!
To illustrate the importance of this concept, we offer the track record (shown above) of the late Bill Ruane, as quoted by Warren Buffett in his famous address at Columbia Business School in 1984 entitled "The Superinvestors of Graham-and-Doddsville."
In the table, the annual performance of his portfolio is shown in the left-hand column of numbers, and the performance of the S&P 500 with dividends reinvested is shown on the right. Years in which his portfolio underperformed the S&P are shown in red. It is clear that his portfolio outperformed the S&P by a staggering amount over the years, but it is also clear that his investors had to stomach some gut-wrenching years of underperformance in order to get there.
This is particularly notable in the first four years of the record cited by Buffett, the years 1970, 1971, 1972, and 1973, when Mr. Ruane first took over the investment partnership. In those years, his performance lagged every single year, in some cases by a wide margin. In fact, in the first three years it lagged the S&P but at least had positive returns; in 1973 the markets experienced a severe bear market but Ruane's portfolio was down even more, by almost ten percentage points worse than the S&P.
How many investors today would have held on through such a period of underperformance? And yet, according to Mr. Buffett, from the time he took over to the most recent quarter available when he gave the speech in 1984, Ruane's investment process returned a cumulative gain of 775.3% versus the market's 270.0% over the same time period. In terms of annual return, Ruane's investors enjoyed a compound annual growth rate of 17.2% versus the market's 10.0%.
Investors inevitably focus on the annual calendar returns, and the media reinforces this obsession, but Ruane's record shows that what really matters is the long run. We like to emphasize this critical investment truth especially during periods like this one, when our annual performance numbers are very good. Investors should understand that, while annual numbers may be less arbitrary than quarterly or daily performance numbers, they are still shorter periods than real investors with long time horizons should be focusing on.
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