A Curious Quarter
A few months ago, we were reading this post about veteran investor George Vanderheiden’s investing lessons, and one of the key points he made is that manias tend to end at the start of the new year. While we’re not entirely sure if some of the manias from 2020 are quite over with, we have seen a strong correction in a number of them. In Q1, we saw a large correction in growth stocks which had gotten too aggressive in their valuations, NFT bubbles pop, rise again, and then pop one more time. We observed a significant deflation of the SPAC bubble, and of course, Gamestop happened. Obviously, one quarter (or data point) doesn’t quite make a trend but three out of the last four year’s Q1s have seen significant volatility. So, perhaps there is something to Vanderheiden’s assessment.
Each of these volatile periods have provided opportunities for investment, but more importantly, also opportunities for learning, and this quarter was no different. So below, we talk through some of our observations and learnings over the quarter, which we hope you’ll find useful.
A long-term time horizon is a super power
The funny thing about this quarter is that despite all the volatility and bubbles forming/popping/reforming, the key indices performed very well. The S&P 500 was up 6% in total return terms and the MSCI All World Index was up 4.5%. If you had checked prices for the indices at market close on 31st December 2020 and then taken a 3 month nap and awoke to check the prices on 31st March 2021, you would have thought all was well in financial markets. You would have been saved from drama, potential heartache, and a lot of distraction. Similarly, sleeping through 2020 would have also been great advice in hindsight (you couldn’t go anywhere anyway!).
Now, this will not always be the case. For example if you were an investor in the Nikkei, you would have had to sleep for over 30 years to see positive returns, so some diversification in your portfolio is important. But time and time again, having a long-term horizon has proven to be one of the key ingredients to success in investing.
This concept also brings us to another point. One of the most talked about stories this quarter was the blow up of Bill Hwang’s family office, Archegos Capital. Without knowing Hwang, it’s difficult to understand what his priorities were and perhaps he had stashed away enough that he didn’t care about the money he put at risk (hard to believe but stranger things have happened). But we’re regularly shocked by how many funds and portfolios have been taken down by excessive leverage. If the returns on a portfolio are determined by the equation where Portfolio Value = Initial Amount * ((1 + Return) ^ Time), stories like Archegos’ implosion imply that investors seem to focus only on the Return variable but often forget about the most important variable of the equation, Time.
Let’s do this mental exercise: would you rather have a portfolio that compounded at 10% for 10 years or one that compounded at 5% for 30 years? Using the formula above, it’s clear the latter would give you a much better overall return. Granted, if you’re going to be an active investor, you want to outperform over your period of investing (otherwise what’s the point?) but the key message here is that you need to let compounding work, and your best bet is to not interrupt it. This is why the Archegos event reinforced to us that we must never do anything to get us taken out of the game (i.e. leverage or heavy use of derivatives), because if you are taken out of the game, you will not be able to let Time work for you.
Drawdowns are hard
We’ve been getting a number of inbound requests for internship placements over the last few weeks as the year winds down and students try to secure a summer job[1]. In order to impress, we find these enterprising students giving us their views on macro events or asking questions about valuations. They do this, because that is what they’re taught in schools. They’re taught investing is about numbers, forecasts, and discounted cashflows, and while this is partially true, schools woefully underprepare you for the emotions that go into investing.
From the highs of Feb, there was a brutal rotation in the growth stocks in our and our client’s portfolios, which, in full honesty, was not easy to stomach. However, we don’t feel bad about this, because no matter who you are, and how much experience you have, drawdowns suck. You start to regret not selling or trimming (even though you fully believe in the company’s long term potential), you start to re-think valuations and assumptions, and you start to imagine chucking it all in and retiring on a beach in Thailand. Again, we don’t care who you are, drawdowns are rough. Even Buffett sold all his airline stocks in the lows after lockdown only to see them bounce back a few months later.
However, the key to drawdowns we learned (or hoped we learned) this quarter is that the only way to stick with an investment is to 1) go back to facts and re-underwrite your thesis. This exercise also helps to remind yourself that short-term movements in stock price don’t reflect the quality of the underlying business and that 2) learn to embrace the pain. Practitioners of Brazilian Jiu Jitsu will know this concept well, as anyone who has ever practiced the sport will know how rough it is. You’re consistently getting smothered, having your limbs bent, taking the extreme pressure of someone else’s full weight, and often getting choked out. In the early days of my practice, I found this pain and pressure quite insufferable, and in frustration, I turned to an experienced student and asked if it gets any better, he turned to me and said “it doesn’t, in fact it gets worse, but you get used to it.” And that, we think is the key to drawdowns, they are never not going to hurt, but you have to get used to them, stomach them, and take them as the table stakes of investing.
This quarter, we observed, by watching our peers and funds we admire (and have invested in), that mediocre investors panic in drawdowns, good investors take the pain, but great investors use it to their advantage and add to positions. That said, each reason behind a drawdown is a bit different and we’ve seen investors who did wonderfully in the last drawdown, fail the next time around (as the adage goes; investing is not complicated – but certainly isn’t easy!).
The ridiculousness of quarterly returns.
The timing of the drawdowns this year lit a lightbulb in our head that made us realize how ridiculous quarterly returns posted by funds are. Now we know why funds post them, it’s almost a requirement, because the short-term nature of human thinking is inbuilt to almost everything we do, including investing. However to give you an example of why quarterly returns mean almost nothing, take these two examples:
Fund 1: Peaks on December 31st 2020, corrects through Q1, finishes on 31st March 2021 down 30% YTD.
Fund 2: Peaks Feb 15th 2021, corrects for 30% over the next 3 months, but due to late peaking finishes 31st March 2021 up 5% YTD.
While the end result is the same, given what you know about how markets react to quarterly numbers – which fund do you think would be perceived as worse off? It’s odd that we place so much influence on arbitrary calendar dates to determine fund performance, when in reality it’s probably the rolling 3-5 year returns that truly matter.
It’s been a curious quarter to say the least and while we came out of it just fine and then some, it was an opportunity for us to re-learn a number of concepts about investing. We hope our learnings were useful to you as well.
Thanks for reading and happy investing!
[1] Just in case, as of now, we’re not taking any interns this summer