Book Review: Joel Tillinghast’s Big Money Thinks Small

Joel Tillinghast is not a household name, even among active investors.

He should be.

Tillinghast is the manager of the Fidelity Low-Priced Stock Fund, and he’s beaten both the S&P 500 and the Russell 2000 by 4% per year since 1989. And while 4% might now sound like a large number, it makes an enormous difference compounded over time. A dollar invested with Tillinghast in 1989 would have grown to $32 over the past 27 years, whereas that same dollar invested in an index fund would have grown to $12.

So, Tillinghast is a manager you should take seriously. And in Big Money Thinks Small: Biases, Blind Spots, and Smarter Investing, Tillinghast shares some of the tricks of the trade he’s used over the past three decades.

Tillinghast breaks the investment process down into five basic principles:

  1. Make decisions rationally
  2. Invest in what you know
  3. Work with honest and trustworthy managers
  4. Avoid businesses prone to obsolescence and financial ruin
  5. Value stocks correctly

Making decisions rationally sounds obvious, but it can be exceedingly difficult in the stock market. As Tillinghast puts it, “…the folklore of stock exchanges has depiscted them as crowded, anonymous carnivals of mass delusion and mayhem, with a whiff of sin. In a venue where avarice and envy are constants, no one expects decisions to be morally ideal.”

That’s not exactly an ideal environment for thoughtful, detailed stock research… which is why so few investors succeed.

Tillinghast walks us through some of the psychological minefields first explored by Daniel Kahneman and Amos Tversy, who are considered to be the pioneers in behavioral finance. But he stops short of throwing human active managers completely under the bus and using purely mechanical investing strategies. As he puts it,

“Given all these oh-so human frailties, some argue that rules-based investing by the numbers is the solution. I don’t fully agree. Algorithms, bots and screens do take the emotion out of investing… [But] I worry that quants forget that stocks are not just numbers but part ownership of businesses, run by people. For now, I think humans are better at gauging whom to trust and visualizing how societies, institutions, and technology might interact and evolve. My ideal is Spock: half human, half Vulcan.”

Tillinghast’s advice to invest in what you know echoes Peter Lynch, the legendary manager of the Fidelity Magellan fund. And interestingly, it was Lynch who got Tillinghast hired by Fidelity in the 1980s.

“Buy what you know” is one of the most misunderstood nuggets of wisdom I’ve ever encountered. No successful investor buys a stock simply because they know or like its products. Warren Buffett didn’t buy Coca-Cola because he likes Cherry Coke.

Buying what you know means investing within your core areas of competence. This comes into play later, in avoiding businesses prone to obsolescence and financial ruin and in valuing stocks correctly. These last two principles are impossible without an in-depth understanding of the business and industry.

And speaking of valuation, Tillinghast relies heavily on the earnings yield (the inverse of the P/E ratio) and on the Shiller P/E or CAPE. He tends to keep his valuation analysis simple, as additional complexity generally just increases the odds of failure.

Perhaps Tillinghast’s best advice is to be comfortable with ambiguity and failure, as being right 55% of the time is actually really good in the world of investing. As he puts it, “…during raging, thematic momentum bull markets, I lag pathetically.”

That’s important to remember. Even the greatest investors get it wrong quite regularly and often underperform their benchmarks for long stretches. So longevity in this business often comes down to embracing failure and learning from mistakes.

If you want to better understand value investing, pick up a copy of Tillinghast’s Big Money Thinks Small. My compliments to the author on a solid, well-researched book written from decades of experience.



Book Review: The Best Investment Writing

Cambria Investment Management’s Meb Faber has always done excellent research. I read his first published book, the Ivy Portfolio, years ago and keep a copy in my office.  Ivy did a lot to change my views on alternative investments, which I now use extensively in my practice.

Faber rarely tries to reinvent the wheel. In fact, a lot of his work centers around studying and replicating the work done by others. That was the focus of Ivy and his more recent Invest With the House: Hacking the Top Hedge Funds, his collaboration with AlphaClone, and his excellent blog The Idea Farm.

True to form, Faber has compiled recent work from some of the best investment writers in the business into eminently readable new book, The Best Investment Writing: Selected Writing From Leading Investors and Authors.

As Faber comments, investors today are completely saturated with information and choice; “too many market experts shouting too many conflicting opinions at us,” which leads to bad investment decisions.

Faber has done his readers a service by hacking through the noise and leaving them with a curated volume of very solid and mostly timeless investment advice. This is not a “how to” book that will teach you a new trading system, and it certainly won’t give you a top-ten list of stocks to buy. But it will make you a better investor and give you a more nuanced perspective.

Every essay included in the book is worth your time to read, but there are a couple that particularly stuck with me. Jason Zweig, a respected columnist for the Wall Street Journal, writes about his experiences trading antiques with his parents as a child. In the 1970s, long before the internet and Antiques Roadshow, the collectibles market was extremely opaque and illiquid. If you were an astute collector who had done their research and knew what they were doing, you had a major information advantage and could earn excellent returns.

Today, that’s no longer the case. The returns Zweig consistently earned with his parents are simply not possible when you have an army of collectors with smartphones able to do instant research at every estate sale in America. Of course, the parallels to stock investing are clear. As Zweig writes,

Decades ago, stock-picking was a handicraft in which information moved slowly and unevenly, so the person who knew the most could perform the best – by a wide margin. Think of Warren Buffett buying such tiny flecks of corporate plankton as Sanborn Map and Dempster Mill Manufacturing. Today, with more than 120,000 chartered financial analysts and 325,000 Bloomberg terminals worldwide and with Regulation FD requiring companies to disclose material information simultaneously to all investors, the playing field is close to perfectly level.

If you’re applying the tools that worked so well in the inefficient markets of the past to the efficient markets of today, you are wasting your time and energy. An investor who devotes weeks or months of research to analyzing a single widely-traded stock is like an antique dealer driving across the back roads of New England searching for bargains that, for the most part, disappeared decades ago. It isn’t impossible that you will find a bargain, but the odds that the rewards will justify the pursuit are low.

I also found Patrick O’Shaughnessy’s essay “Alpha or Assets” to be particularly insightful, and I’d recommend it to anyone looking to hire a money manager or advisor. O’Shaughnessy writes that “strategies should be built for alpha, not scale,” which should be obvious. A manager with a fiduciary responsibility to act in his client’s best interest should be most concerned with the performance of the portfolio, not his ability gather more assets. O’Shaughnessy writes:

Professionally managed investment strategies have two components: an investing component (seeking alpha) and a business component (seeking assets). Outperformance is one goal, scale is another… In the asset management business, two variables matter: fees and assets…. When fees fall, assets need to rise. For assets to rise across a business, the strategies offered need to be able to accommodate more invested money.

He points out that more assets are great for the business, but they’re often terrible for returns, as the manager can’t trade smaller or more thinly traded securities without moving the market.

This brings up interesting questions about fees. In a vacuum, low fees are wonderful. But if low fees force a manager to compensate by gathering more assets… and reducing the effectiveness of their strategy in the process… that low fee can prove to be quite expensive.

I’ll wrap this up with what is probably the best headline for article I’ve seen in years: “Even God Would Get Fired as an Active Investor.”

Wes Gray, whose work I’ve reviewed in the past, showed empirically that “an active manager who was clairvoyant (i.e. ‘God’), and knew ahead of time exactly which stocks were going to be long-term winners and long-term losers, would likely get fired many times over if they were managing other people’s money.”

When even the Almighty would get fired, you know it’s a rough business.

My compliments to Meb Faber and to each of the writers he highlighted for putting together a very solid volume.

Invest Like a Guru: How to Generate Higher Returns at Reduced Risk With Value Investing

I use the research site GuruFocus almost daily. It’s my go-to source for fundamental stock research, and the screeners and graphing tools alone would be well worth the subscription cost.

So, I was thrilled to find out that GuruFocus founder Charlie Tian, PhD recently authored a book, Invest Like a Guru: How To Generate Higher Returns At Reduced Risk With Value Investing.

Tian doesn’t have a background in finance. He’s a scientist with a PhD in physics and an expert in fiber optics and lasers. Perhaps because of his unorthodox background Tian approaches the investing process in a scientific way, picking apart the strategies of successful investors to see how they work. Much of Invest Like a Guru – and GuruFocus too, for that matter – is focused on the strategies of wildly successful value investors such as Warren Buffett, Peter Lynch and Donald Yacktman.

The dominant theme of the book is quality. Buffett famously said “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” and Tian spends most of Invest Like a Guru expanding on that core idea. Chapter 6 is particularly useful as a 20-point checklist of criteria to look for when seeking out quality companies, including consistent profitability, capital efficiency and insider ownership.

But while Invest Like a Guru is full of solid advice in what to look for in a stock, it’s far more useful in telling you what to avoid. As a case in point, Tian dedicates a chapter to deep-value investing, and I personally consider this the most important chapter in the book. I myself have gotten suckered into deep-value plays in the past, and they rarely seem to work out as planned or on the timeframe I had hoped.

Deep-value investing is what Warren Buffett called “buying dollar bills for 40 cents” earlier in his career. Later, he mostly eschewed the strategy, calling it “cigar-butt” investing.

The rationale is easy enough to understand: It’s hard to lose money buying a company that is worth more dead than alive. If a company’s net assets are worth significantly more than its current market price, management could sell off the company for spare parts and deliver a decent profit to shareholders. And generally, that would be the right move. Remember, if a stock is trading that cheaply, chances are good that it is a company with very deep problems.

The problem is that it never quite works out that way. Monetizing assets is messy and complicated, and management has a vested interest in keeping the enterprise going. And the longer they do, the more value gets eroded.

As a case in point, consider the case of Sears Holdings (SHLD). Eddie Lampert and Bruce Berkowitz – both respected value investors – have effectively bet their careers on Sears in the belief that its real estate and brand portfolios represented massive untapped value. They problem is that the Sears retail business continues to deteriorate around them. They may eventually unlock the value they had hoped to, but it will have cost them dearly in money, reputational damage and – perhaps most importantly – opportunity cost. Had they focused their energies elsewhere, they might have made far better profits with far less headache.

Buffett himself learned the same lesson with Berkshire Hathaway (BRK-A), which was a failing textile producer when Buffett originally bought it. Berkshire eventually failed, but only after Buffett had wasted untold time and energy (not to mention money) trying to keep it afloat. Buffett called his purchase of Berkshire Hathaway a “$100 billion mistake.”

Tian finishes the chapter with the simple observation that “There are better ways to make money.”

If you’re new to value investing, I highly recommend Invest Like a Guru. But even if you’re a seasoned investor, you’ll find plenty of insightful food for thought. My compliments to Tian on a solid addition to the value investor’s library.

Charles Lewis Sizemore, CFA is the principal of Sizemore Capital Management, a registered investment adviser based in Dallas, Texas serving families and high-net-worth persons.

Book Review: The Snowball Effect

Timothy McIntosh is a man after my own heart. The Tampa, Florida-based portfolio manager and financial planner dedicated an entire book —  The Snowball Effect: Using Dividends & Interest Reinvestment To Help You Retire On Time – to expand on one of my very favorite topics: the compounding effects of dividends.

As the title suggests, McIntosh compares dividend compounding with a snowball rolling down a hill. It may not look impressive at first, but given a long enough roll, the returns can become enormous.

If you have any doubts as to why dividends matter, I encourage you to read the very first chapter of Snowball Effect. It’s a history of secular bear markets going back to the early 1900s. Starting in 1906, the Dow Industrials returned a negative 0.24% per year for the next 18 years. Starting in 1929, the Dow returned just 0.11% per year over the next 25 years. And from 1966 to 1982 and from 2000 to 2011, the Dow returned 0.21% per year and 0.32% per year, respectively. Needless to say, you’re not going to get rich fast in a stretch like that.

Yet if you include reinvested dividends, those same four periods enjoyed total returns of 6.2%, 5.5% 4.8% and 2.8%, respectively. While by no means “get rich quick” money, the returns including dividends are respectable. McIntosh also points out that dividend-paying stocks generally fall less than the broader market during bear markets. Since 1927, high-dividend-paying stocks have had a downside capture of about 80%, meaning that they have, on average, only fallen about 80% as much as the broad market averages.

It’s impossible to know with any certainty that a secular bear is about to rear its ugly head. But as McIntosh points out, high starting stock valuations are generally a reasonably good predictor of future returns. McIntosh mentioned the cyclically-adjusted price earnings ratio (“CAPE”) specifically, and I would add that today the S&P 500 is trading at a frothy  CAPE of 28.5… which implies flat to slightly negative returns over the next decade. This means that dividends are likely to have an outsized impact on investor returns for several years to come.

In later chapters, McIntosh expands beyond dividend stocks and bonds and into more active strategies such as writing covered calls. If you are new to covered-call writing – which involves selling an out-of-the money call option against a stock you own in the hopes of pocketing the premium when the option (hopefully) expires worthless – I recommend you read what McIntosh has to say on the subject. I’m a little embarrassed to say that he pointed out some tax ramifications that were new to me. For example, it is possible to inadvertently lose the long-term capital gains tax treatment of your underlying stock by selling an in-the-money option against it. Having your capital gains bumped from the lower long-term rate to the higher short-term rate can come as a nasty shock.

Finally, McIntosh ends Snowball with a 100-stock model portfolio based on his quantitative ranking of dividend yield, dividend growth and other factors. By and large, it is a solid list of dividend stocks you’d be well served to buy, hold and forget. Though if I could offer one suggestion, it might be to add an additional screen for earnings quality. You want stocks that hike their dividends based on real earnings growth, not new debt issuance or financial engineering. This would prevent habitual offenders like International Business Machines (IBM) from making the list.

All in all, Snowball Effect makes solid, effective arguments for dividend investing, and investors would be wise to heed its advice.

Review: The Index Revolution

9781119313076.pdfOnce in a long while, you come across a research paper that fundamentally changes your thinking on a subject. Well, I had one of those moment years ago the first time I read Charles Ellis’ paper “The Loser’s Game.”

In the paper, Ellis uses tennis as an analogy for investing. Professional tennis is a “winner’s game” in that the victor wins by skillfully scoring more points. But amateur tennis is a “loser’s game” in that the victor simply wins by not losing. The winner doesn’t win by superior skill but simply by making fewer mistakes than his equally hapless opponent.

Ellis noted that investing, like amateur tennis, had become a loser’s game. With so many talented and bright professionals all attempting to outsmart each other, outperforming based on skill and research had become almost impossible. Ellis’ solution was simply to win by making fewer mistakes (and absorbing fewer frictional costs due to taxes and commissions). And for him, this meant embracing indexing.

I first read the paper in the early 2000s, though Ellis originally wrote it in 1975, two years before I was born. So it’s safe to say that Ellis has been at this game for a long time and that he was at the forefront of the shift away from active management and toward passive indexing.

The Index Revolution: Why Investors Should Join It chronicles Ellis’ intellectual journey to becoming an indexer, and Ellis is uniquely qualified to tell that story. His career spans the rise and fall of professional active investing as we know it. When Ellis first started his career a half century ago, most professional investing was done by bank trust departments and consisted of buying and holding a basket of dividend-paying blue chips for years at a time. 90% of trading was done by individual amateur investors. It was a situation ripe for exploitation in which a hotshot manager with a good research team could realistically expect to beat the market… and often did.

But by the mid-1970s, a massive influx of talented and motivated managers armed with better and better technology had swamped the market, and today more than 98% of all trading volume is done by professionals and algorithms.  And as a result, the outperformance that existed when Ellis started his career has all but disappeared. Only 17% of active mutual funds beat their respective benchmark over a 10-year period.

It’s not that the managers are incompetent. In fact, the exact opposite is true. Collectively, they are too good, and they can’t beat the market because they are the market. A stud manager is no longer competing against dentists and lawyers but against other stud managers.

The first half of the book is essentially a history lesson on the past 50 years of professional money management. Ellis dedicates the second half of the book to really making his case for indexing, highlighting its generally superior performance, lower fees, tax efficiency, etc.

He also addresses a concern of mine, though he dismisses it somewhat out of hand. Ellis absolutely has the facts on his side when he touts index funds over their actively-managed cousins. But the market efficiency that makes indexing so powerful is only made possible by the trading moves of the active managers. The professionals force the market into efficiency with their trading. So what happens when “everyone” fires their manager and dumps their nest egg into a Vanguard index fund?

Ellis points out that this hasn’t been a problem. Indexes — even large ones like the S&P 500 — have had no real issues with rebalancing, even as more money than ever is invested in passive index funds. I agree, it hasn’t been a problem… yet. But I could see a scenario in which the success of indexing drives enough actively-managed funds out of business that the market efficiency they had helped to create though fundamental research breaks down… ironically making active management profitable again. There are other secondary effects of indexing; as Bill Ackman pointed out, because index funds are passive, they are not equipped to vote proxies and accept the corporate governance responsibilities that come with being a large shareholder. Without activist investors to agitate for change, you could end up with complacent management teams running essentially every large company in America.

These are legitimate long-term concerns. Though in the meantime, Ellis’ strategy of low-cost indexing is likely the right one for most investors. My compliments to Dr. Ellis on The Index Revolution and on a long and successful career of playing the loser’s game… and winning!

Charles Lewis Sizemore, CFA is the principal of the investment firm Sizemore Capital Management.