The power of normal

CIO Insights 2Q2009

The big fall from late 2007 to early March 2009 and the subsequent sharp, unexpected reversal in many quoted stock and bond prices undoubtedly had the potential to wreak havoc on the performance results of anybody trying to navigate through these turbulent markets. It is thus worth reiterating the basic framework we rely on to prevent such wild market swings from derailing our investment program. 

We have written and talked many times about the virtues of “compounding”: the exponentially positive effect on investment performance over long periods of time by (1) seeking out investments with readily apparent safety-of-principal and adequacy-of– return features and (2) reapplying this process in a disciplined, repetitive, seemingly continuous fashion. But complementary to the power of compounding, we use an even more elementary force in our investment thinking, namely the concept of “normalcy”. Many statistical theories regularly applied in economics have their roots in normalcy, such as the normal distribution in a probability density function or mean reversion in a time series. For us normalcy in a capitalist context captures the notion that despite all the gut-wrenching ups and downs, such as the ones we experience in financial markets at the moment, there seems to exist a powerful tendency in a host of metrics, e.g. prices, volumes, margins, interest rates, credit spreads, etc. to eventually (r)evolve around some economically rational base level. As my colleague Sven Sommer likes to say dryly, “in the end everything will be normal.”

Value investors implicitly base many of their assumptions and the confidence in their analytical work on normalcy. For example, in the introduction to the 1973-edition of “The Intelligent Investor”, perhaps presaging the painfully difficult financial market conditions that would prevail for nearly a decade, Ben Graham wrote: “Through all their vicissitudes and casualties, as earthshaking as they were unforeseen, it remained true that sound investment principles produced generally sound results. We must act on the assumption that they will continue to do so.” More recently, during the last week of June 2009, Warren Buffett was asked by a television reporter whether he can spot any “green shoots” in the figures and imminent prospects of his investee companies. He candidly replied that he didn’t, but at the same time exuded unwavering assuredness that they will sprout sooner or later.

Simple and boring as it is, normalcy comes with one crucial caveat. Like compounding it requires the willingness and ability to exert patience. For a market participant with a short investment horizon and/or in a financially overextended situation, normalcy is impractical at best and non-applicable at worst. For us as unlevered long-term investors, however, the belief in normalcy helps us remain committed to our equity investments in times when their outlook seems bleakest. We think that this underlying mindset has served our loyal investors well in the past and will continue to do so in the future.

Sincerely,