Buffet vs Modigliani-Miller
In our last post, The Fourfold Pattern, we explained that the “possibility effect” causes highly unlikely outcomes to be weighted more heavily than they deserve. People who repeatedly buy lottery tickets demonstrate this logical misjudgment, as they are willing to throw away so much money for a very small chance to win. Because of the possibility effect, we are naturally inclined to overweight small risks and are quite happy to overpay to eliminate them altogether.
We think the same behavioral errors that tempt “gamblers” to buy lottery tickets, seduce “investors” to speculate in high risk stocks. The result: a structural overvaluation in excitement and a systematic undervaluation in high quality stocks. Contrary to decades of academic research, high risk does not always equal high reward, particularly when “high risk” comes with a “lottery ticket” premium. The flip side, of course, is that near-certain outcomes are regularly undervalued by investors. Possibility generates enthusiasm, eagerness and anticipation, which we are willing to pay for. Certainty engenders boredom and requires endurance and persistence, traits not particularly common to today’s traders. Evolution has hardwired investors to buy “sexy” and sell “humdrum.”
In January 2009, James Montier published a piece while still at Societe Generale titled, The Trinity of Risk, whereby he highlights three primary dangers of permanent capital loss as noted by Benjamin Graham. Valuation risk is perhaps the most obvious – buying an expensive asset means that you are reliant upon all the good news being delivered with no margin of safety. Business or earnings risk is the danger of a loss of quality and earnings power through economic changes or deterioration in management. And balance sheet or financing risk boils down to the presence of financial weakness that may detract from an otherwise attractive business.
Put simply, a portfolio constructed of high quality companies should minimize Graham’s Risk Trinity and result in superior risk adjusted performance. History suggests that many businesses are able to resist the forces of competition and maintain higher profitability, independent of economic conditions. Contrary to popular theory, high and stable returns are a byproduct of structural competitive advantage, not balance sheet leverage. These companies are not “sexy” but they do not go bankrupt. What they are is exceptionally profitable. What they provide are exceptional returns. And these returns are delivered to investors in the form of dividends, stock buybacks, and earnings growth.
Recent work from GMO has provided Evidence in Favor of Buffet and Against Modigliani-Miller. The authors demonstrate that, “Empirically, companies with persistently high profitability have lower leverage, and companies with persistently low profitability have higher leverage.” The gap in the above chart is striking in perspective and suggests that higher profitability is associated with lower financial risk. Apparently, investors can have their cake and eat it too, with lower risk and higher returns.
Perhaps even more striking is the sustainability of this advantage. GMO finds that those businesses which were profitable stay profitable. Accordingly, the market offers up predictably higher profits for lower-risk companies and has continued to undervalue the lower-risk fundamentals of higher-quality stocks. Or, in Kahneman’s terms, near-certain outcomes are regularly undervalued by investors.
Students of Modern Portfolio Theory are encouraged to take more risk in exchange for higher returns. But good students know there are exceptions to every rule. Low-risk stocks have substantially outperformed their high-risk peers measured by any yardstick over time.
Investing in high quality companies is an easy decision for us given today’s highly fragile economic landscape. At the same time, we can exploit the persistent opportunity offered by more certain profits, along with the average investor’s lack of interest in these boring businesses. While interest in dividends is growing in a zero interest rate world, speculators will always be tempted by the possibility of the next jackpot, “story stock” or social media IPO (sorry Andrea, I couldn’t resist). The result is the systematic undervaluation of boring stocks, which provides us with the potential for systematically higher returns over time.
Despite the obvious benefits of this approach, not many have the willpower to stay true to the concept. Investors crave excitement. Stability is simply not exciting. As a result, many of our peers find it hard to resist the temptations of hugging the benchmark, following the herd, or going for a little excitement even if it’s “just for a second, just to see how it feels.” We are quite happy with boring when it comes to equity investing. We prefer to focus on exceptional companies rather than speculate on mediocre businesses with uncertain futures. By limiting our circle of competence to those companies with sustainable competitive advantages, we are maximizing our probability of success by minimizing the Trinity of Risk.