“Activity is the enemy of investment returns.” – Warren Buffett
We believe there are a couple of reasons why this statement is spot on for most investors. First, the primary input many people use is whether the security has performed well or poorly. Some investors are quick to take profits on securities that have gained even when the fundamental story is still intact (e.g., the security has appreciated in line with things like underlying growth in sales, earnings or cash flow per share). On the other side of the spectrum, many investors have a propensity to buy into market segments that have performed exceedingly well and parting with those that have ‘failed to keep up.’ Reversals are common. Securities that have been disappointing to own could prove to be the winners going forward. Others that have performed exceedingly well can fall precipitously if their valuation metrics compress – for a variety of reasons. As you know, our approach is not based upon buying or selling based upon price movement per se. Rather, we actively seek out securities that tend to perform differently over time. We also look to identify and patiently own segments that are inexpensive relative to their own history and other market segments. That’s because, when conditions improve and/or sentiment turns favorable, these securities can surprise on the upside.
“I view diversification not only as a survival strategy but as an aggressive strategy because the next windfall might come from a surprising place.” – Peter L. Bernstein
As steadfast proponents of diversification, we believe this statement is powerful. First, history shows that most market segments come into and out of favor. Indeed, pronounced leadership changes often occur when they are least expected. Therefore, investors are well served to purposefully own investment assets that have historically performed differently from one another over time. True diversification entails a willingness to go against the grain by actively seeking opportunities to invest in market segments that are out of favor with respect to most investors. Collectively, most investors shun investments that have performed poorly of late and where sentiment is palpably low. The key to avoiding ‘group think’ is using valuation metrics as a primary input and then exercising patience. For instance, at what proved to be the bottom of the GFC (great financial crisis) in 2009, most investors viewed things like the S&P 500 as inherently risky.i However, long-term oriented investors who use valuation as a primary input were more readily able to not only stay the course but to add to positions. Indeed, we think it is helpful to ask things like, ‘What is the likelihood that this segment will perform poorly over the next 5 years if the economy improves?’ The reverse is also true for dearly loved segments. Will they perform well if the economy is not robust in light of current high valuation metrics?
The table below shows how difficult it is for even well-known and resourced companies to stay at the top of the leaderboard.
One of the things that make it difficult for stocks to stay on top is the fact that valuation metrics can expand such that their share of an index’s value significantly exceeds their respective earnings contribution. As the chart below shows, the PE ratio for the largest 10 components of the S&P 500 is elevated compared to the remaining 490 stocks (all equal weighted). This was true during the dotcom bubble. The largest and most expensive stocks fared particularly poorly from their highs. Historically, the bottom 490 have performed relatively well when the top 10 lose significant valuation (see the table below).ii
Some additional insights from Peter Bernstein
Peter Bernstein was a well-known and highly thought of investment manager who wrote some terrific books on investing. These include Against the Gods: The Remarkable Story of Risk and The Power of Gold: The History of an Obsession. The lessons he shared over many decades have stood the test of time.
In an endnote, I have embedded a link to a collection of things he said and wrote over his distinguished career.iii I believe you will find they are insightful and helpful.
As always, we appreciate the trust and confidence that you have entrusted in our team. Please let us know if you have questions about this letter or if we can otherwise be of help.
W. Richard Jones, CFA
Partner, Harmony Wealth Partners
i From its low of 666 on March 9, 2009, the S&P’s value has increased nearly 9-fold price only (e.g., excluding the benefit of dividends paid).
ii 
iii https://novelinvestor.com/wise-words-from-peter-bernstein/
Here are a few more of my favorite quotes from Mr. Bernstein –
- “What’s comfortable is not the right way to You must own things that you’re uncomfortable with. Otherwise, you’re not really diversified.”
- “Survival is the only road to ”
- “The constant lesson of history is the dominant role played by Just when we are most comfortable with an environment and come to believe we finally understand it, the ground shifts under our feet.”
Any opinions are those of the author, are subject to change without notice and are not necessarily those of Raymond James. This material is being provided for information purposes only and does not purport to be a complete description of the securities, markets, or developments referred to in this material and does not constitute a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results.
Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions. Investing involves risk and investors may incur a profit or a loss regardless of strategy selected, including asset allocation and diversification. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. International investing involves special risks, including currency fluctuations, differing financial accounting standards, and possible political and economic volatility. Investing in emerging markets can be riskier than investing in well-established foreign market. Raymond James is not affiliated with nor endorses the opinions or services of any of the above-named organization.
