21 Jan The Road Not Taken December 2015
The Road Not Taken
Robert Frost wrote this poem in 1920 about how a traveler was faced with a choice. There were two paths to choose from and he was unable to see the end of the roads because of trees and bushes that blocked his view. Both paths had changed over time as the forest had changed to reclaim portions of the road; with it, the road was changed to adapt to the forest. Frost’s traveler “took the one less traveled.” Investing has its own similarities to the decision Frost’s traveler faced. There is more than one path, the paths change over time and nothing is guaranteed.
Just as the traveler was not able to see the end of the path, we cannot see exactly where our investments are going. We know the general way they will go, but we don’t know the precise route. One thing to be sure of is that it will not be a straight line. A 5 year return of 10%/yr., does not mean a return of 10% every year. We all know that one or even two of those years could have even been negative. Unforeseen events are everywhere. The headlines of Detroit’s bankruptcy, Puerto Rico’s expected bankruptcy and Chicago’s circling of the fiscal drain. Given these dire headlines about municipal bankruptcies, who would have thought that the best bond asset class return last year and YTD this year has been municipal bonds. Municipal bonds are ahead of the S&P500 YTD and trial only US Growth among all equity asset classes. Strange indeed that growth stocks would be ahead of munis given the dearth of economic growth we have had for years.
The paths that we travel change. We are all familiar with the Dow Jones Industrial Average (DJIA). We know that it is comprised of 30 stocks. The index is 128 years old and has had 53 changes in its components. Originally, the DJIA had only 12 stocks. Some of the prior constituents are: American Cotton Oil Co., Chicago Gas Co., Distilling & Cattle Feeding Co. and National Lead Co. When Frost wrote his poem, the only component of the DJIA that is still there today is General Electric. 29 companies have been added since then including McDonalds, IBM, Coca-Cola and Procter & Gamble.
While the path we are on may change itself, it is still the path we take to reach our goals. We can always decide to change paths (allocation). Through analysis, we may decide that a different path is more appropriate and make the change ourselves. Using cyclical valuations to determine allocation is an example. Life changes will often cause a path change as well.
Some people see the path of investing as the same thing as gambling. They would think of the investment road as a gauntlet to run with surprises around each bend. When you turn on CNBC, the commentary and advice is about what to do today and they use phrases like bear raid, how to play it and other such gibberish.
Investing is not gambling. While analogies to gambling can be helpful, they break down in a hurry. It always makes sense to look at the odds. A simple example would be two (and only two) companies are bidding on a project that the winner will make $1B from. If each firm has an equal chance of being awarded the contract, then each company is worth $500M before the contract is awarded. After it is awarded, one will be worth zero and the other $1B. Any purchase of either company for less than the $500M value, is a good investment decision. Some would say: “It is a good bet.” In this regards, investing is like gambling. You have 50% of earning $1B. A reasonable price to pay is anything less than $500M. Gambling, just like investing, involves odds.
However, there is a distinct difference. The longer you gamble, the more assured you are of a loss. At the casino, the odds are stacked against you. Instead of a 50% chance of winning, you may have a 49% of winning. (This is a 51% of losing.) I should be fair, these examples have been on a 2-to-1 payout. If the odds of winning are 25% and you get $5 for each $1 invested for winning; that works out just fine. In this instance, you get $5 for every $4 you gamble. But casinos don’t work like that. Investments do.
The longer you invest, the more assured you are of a gain. As you travel further down the path, the more you will be able to see. The longer you invest, the more assured you are of a gain. As you travel the investment path, even though it is not a straight path, you get closer to your goals. It is not a straight line and dangers are on it. For me, the big key is to not take risks with anything that you cannot afford to lose.
We also have a choice of paths to take. Every investor is different. With their unique goals, risk tolerance and abilities to set aside money to invest. Some paths are more inviting than others. The paths to choose from are plentiful.
When it comes to equity investing, there are two broad styles to choose from: Growth and Value. Growth investors seek companies that offer strong earnings growth or the potential for strong earnings. These are the Microsofts and Intels of 30 years ago. Value investors seek companies with good fundamentals that have fallen out of favor or companies that are misunderstood. History shows that growth stocks have the potential to greatly outperform other investments though are more volatile. Growth and value stocks typically diverge in their paths.
For me, I am proud to be a value investor. I know that my advice is biased and it is biased towards value investing. Over time, value investing has yielded better returns than growth investing with less volatility. I like value investing. Sometimes that’s good and sometimes that’s bad. For the past several years, value investing has been bad as it has lagged growth investing. Year to date, large cap growth stocks are flat, while small cap value stocks are down 10.1%. Growth has been the place to be in US stocks this year. Over the past 10 years, growth has outperformed value by 2.3%/yr. This had made value investing a little more difficult to be excited about. What has caused this recent triumph of growth over value?
The most likely cause of this is not the growth of the corporate sales but is due to the decline in interest rates. This is changing.
The value path may look a bit overgrown right now. An investor could look at the options and decide that not enough excitement is being generated about value investing. A traveler may say that not enough steps were on the leaves and the way may not be safe. It is likely that value investments will shine in the rising interest rates we will have over the next few years. And the value investors will be able to cite Frost’s last stanza:
|I shall be telling this with a sigh|
|Somewhere ages and ages hence:|
|Two roads diverged in a wood, and I—|
|I took the one less traveled by,|
|And that has made all the difference.|