7-Footers In A Sea Of Pygmies

My Comments: Yesterday, I talked about amateurs and professionals when it comes to investing money. About how emotions get in the way at crucial times, often promoted by people who rarely have any reason to say what is in YOUR best interest, only what is in THEIR best interest. If they can persuade you to subscribe to their newsletter, they have won.

Here’s an article that creates an analogy that you can use if you are one of those who insist you can get it done better by yourself. You have little need for professional advice. This is OK  since it’s your money you’re working with, but for those who need help, this is one of those insights that professionals rely on to help them make better decisions on YOUR behalf.

Jacob L. Taylor, Farnam Street Investments Feb. 11, 2014

Why concentrating on just the averages obscures true market insights.

“If you’re a basketball coach, you’re probably not going to arbitrarily hire a 5’6″ player. You know there may be exceptions, but in general, you’re looking for a 7-footer.”
— Warren E. Buffett

The average male human is 5’8″ tall; most people fall somewhere close to that average. The average NBA player is 6’7″ tall, which is obviously a quite rare height for a human.

During an average year, with average market prices, a typical company will sell for 15 times last year’s earnings. So a 15x multiple equates to 5’8″ on this normal distribution. Benjamin Graham, the father of value investing and a mentor to Warren Buffett, preferred to only buy stocks that were selling for a P/E of 8x or less, almost half as cheap as the normal price businesses typically trade for. He was a real bargain shopper.

Just like being tall usually conveys some advantages on the basketball court, research shows definitively that buying stocks when they’re cheap will provide better returns than buying them when they are expensive. There’s no bigger driver of investment success than the price that is paid: valuation is king. Paying less for something sounds like a no-brainer good idea, but for some reason people develop feelings of euphoria from higher prices, and panicked dismay from lower prices when it comes to their purchase of partial ownership of publicly traded companies.

Whether you’re an NBA GM hunting for tall people or a fund manager looking for attractive investments, it’s important to understand the statistical makeup of the population you’re exploring. Imagine that you visit a tribe where for some reason, everyone was clustered around the same height of 5’2″. Everyone is short– would you expect to find a lot of potential NBA players in that tribe? Probably not (our apologies to Muggsy Bogues). Now imagine a tribe where everyone was at least 6’7″. There are likely a greater number of NBA-size people in that group.

There have been times when markets have had extremely low P/E ratios across the board because of general investor pessimism. People simply wouldn’t pay as much for $1 worth of earnings from the average business, which means there are deals to be had for those who don’t need the warmth of a rosy outlook to take action. Those low P/E times have often resulted in spectacular returns for investors, just like a “tall” tribe would be more fruitful in yielding NBA-sized people. The greatest bull market run in history started in 1982 from a P/E of just 8x. You can basically throw a dart and find something with an attractive risk-reward profile when markets are really cheap. Conversely, there have been times when markets have had very high average prices, which have subsequently performed very poorly for investors. These bubble times are the equivalent of finding the pygmy tribe yielding little NBA-level height.