[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]
