Investment Approach Further Explained
We are all human, including financial advisors, wired to make the same investment mistakes over and over, buying high and selling low, when emotions overwhelm us. Divorcing ourselves from emotion is against our nature. Still, that is what we must do. Fear will lead investors to sell just when an investment's falling price is near its bottom. Over-optimism will cause investors to buy just when the price is at its peak. Disciplining one’s emotional side is no easy task - even for a trained, experienced professional. One must develop some rational, logical process that will maintain discipline in the face of emotion. Without this process, an investor is destined to underperform. This process must be quantitative in nature and steadfast in approach.
Everest's process is value-driven, as we believe the key determinant of long-term returns is the price you pay for an investment in relation to what you are getting (i.e. sales, profits, cash flow). This valuation approach provides a very good “compass” which guides much of our investment process, helping us assess whether prices are cheap or expensive relative to fair value. If the proper valuation metrics are utilized in the case of stocks, starting valuations have about a 90% correlation with returns generated over the following 10 years. This means that how much you pay for something will explain about 90% of what you earn on that investment over the next 10 years. All of our clients have at least a 10 year time horizon so a long-term approach makes sense. We believe by utilizing a valuation compass we can identify when the odds of long-term success are in our favor or stacked deeply against us, and we allocate our clients' portfolios accordingly.
Paying too much for an investment locks in poor returns over the long-run. One can always hope for a greater fool to which to sell at a higher price and this may work in the short-run, but in the long-run, the gravitational pull toward fair value always wins. The strategy of “hope” when odds are against your success due to high valuations is not a good sleep-well-at-night strategy. If one pays a cheap or fair price at purchase, one can sleep well knowing time is on one's side. Only fools abandon caution and blindly invest in things simply because they are going up. Wise investors always buy with a margin of safety, says Benjamin Graham. There is no investment attractive enough that can't be derailed by paying too high a price. To be a successful investor you have to have a process that puts the odds of success on your side and the discipline to follow the process.
Ultimately, Everest's process is geared toward achieving our clients' life goals. Our clients have worked hard to accumulate their wealth. Markets have always been cyclical and will continue to be so. Investors have the opportunity to buy and own various securities every day. Investors have the choice of saying 'yes' or 'no' to what's on the menu in front of them today, knowing that prices on that menu will be different tomorrow. Similar to how patience improves a baseball player's success at the plate, it also can improve your lifetime investment returns. We don't believe we need to swing at every pitch where the odds of success may be lower.
My family spent a long weekend in Los Angeles, where we spent most of our time hiking and biking along the beach. (Our four children had no interest in museums, Disney World, Hollywood, studio tours, etc.; could be why 90% of our vacations are to Colorado). While we were on the beach, I enjoyed watching the surfers. There was a wide range from beginners to experts. As I watched, I was able to discern the beginner from the expert, not in his/her ability when on the board, but rather, by his/her approach and effort expended. I was watching one guy that either lacked the patience or training to wait for the right wave. He repeatedly would attempt to catch every wave, regardless of potential, and repeatedly be disappointed in the outcome as he’d have to paddle back out each time. When the big wave finally arrived, he’d be out of position to take advantage of it and it’d hit him in the face. In contrast, the veteran, knowing he had a full day at the beach, would carefully assess the potential of each wave on the horizon, and leap when the time looked right. He was in position to ride the wave, and did it masterfully. In a fairly short time, the novice/impatient surfer, exhausted, staggered up the beach to call it a day, while the veteran still floated on his board scanning the horizon.
Everest's active asset allocation approach sharply contrasts with most other advisors that establish and maintain a static asset allocation of 60-70% stocks and 30-40% bonds, after measuring a client's risk tolerance upfront. These advisors do not vary this asset allocation when markets get cheap or expensive. Almost every portfolio we see from prospective clients is 60-70% stocks at all points in the market cycle. Often, there are dozens of investments within the portfolio but the overall portfolio behaves as you'd expect. Clients of these advisors should expect to get whatever returns the market provides. If stock rise or fall significantly, they should participate both directions, that's what they signed up for. Most individuals enter these relationships saying they will hold through thick and thin, but reality for investors is very different. Risk tolerance studies show each person's risk tolerance varies according to the direction of the market. When stocks are going up people score as more risk tolerant, not surprising because risk seems to be gone when stocks are going up, but when stocks are going down people all of a sudden become more risk averse. This leads to investors calling their advisors wanting to add to stocks after they have gone up and sell after they've gone down - buying high and selling low. Yes, many advisors will resist these pressures from clients, but many buckle because appeasement retains the client. Unfortunately for the client, if stocks are falling because they were too expensive when purchased, that loss to get to fair value could be a permanent loss.
We believe other advisors' static allocation approach fails to optimize one's portfolio from a risk and reward perspective. In other words, when stock prices are high and therefore more risky, the static approach's exposure to stocks is the same as when stock prices are low and less risky. Everest's approach, consistent with the Buffet quote earlier, is to take advantage of collective market human emotions that drive stock prices way above fair value and way below fair value. We buy when others are fearful and sell when others are greedy, using valuation measures to gauge where prices are relative to fair value. We believe this is a lower risk, more fruitful approach over the long-run.
As compared to other advisors, we more heavily utilize alternative investments (other than stocks and bonds, such as real estate, precious metals, distressed debt, energy, etc.) in client portfolios. There are two reasons for this:
- The more you can include securities in a portfolio that behave differently than each other, the less volatile that portfolio will be without sacrificing returns. In other words, you can build a more diversified portfolio by expanding the types of investments you own.
- By limiting a portfolio to just stocks and bonds, an investor is not availing himself/herself to the full menu; and, there are some very attractive alternative investment opportunities. Larger portfolios are eligible to purchase many investments not available to smaller portfolios. Passing on these opportunities would be like going to a restaurant, tearing the menu in half and only looking at and ordering from the first half of the menu.
We believe our investment approach is fairly unique in a very crowded financial advisory industry. Your choices are which approach you believe is least risky and potentially most rewarding, and who is best-equipped to execute that approach.