Hope Is Not a Strategy

The following commentary was originally posted onFoolFunds.com, the website of Motley Fool Asset Management, LLC, on Jan. 9, 2013. With permission, we're reproducing it here in an edited form.

It's easier to fool people than to convince them they have been fooled.
-- Mark Twain

Happy New Year!

The markets closed out a turbulent 2012 with one last worry: whether Congress and President Obama would come together with an agreement that would prevent the federal budget (and thence the economy) from plunging over the figurative fiscal cliff. During the month of December, more people asked me about whether we were going over the cliff than anything else. OK, except for "What am I getting for Christmas?" But that was more a case of a small set of people asking the same question many, many (many) times.

(Also heard many times: "Why the hell are you going to Nigeria?," the answer to which lies in our just-published recap of our research trip to this fascinating "Sleeping Giant of Africa." See "Nigeria: The Giant Awakens.")

What we witnessed in December was a strange confluence of market factors. First, as is normal, many investors engaged in tax-loss selling so that they could net out losses to lower their tax exposure. With the looming rise in capital gains tax rates, though, December 2012 also saw witness to significant tax-gain selling, whereby investors went ahead and sold stocks that had increased in value, locking in the 2012 tax rate. In addition, fear and hope regarding the fiscal cliff as well as the Federal Reserve's pledge to maintain its zero interest rate policy for the foreseeable future had, in our opinion, the unfortunate effect of continuing to distort stock market returns.

These types of distortions have real implications for investors. For example, I recently ran a screen measuring the stock market performance of all of the companies in the Russell 2000, the most commonly quoted measure for U.S.-domiciled small-capitalization companies. The stocks of companies in the bottom 25% in terms of returns on capital - one of our favorite measures of quality - dramatically outperformed the quartile with the highest returns on capital during the 12 months through October 2012.

In case you have any question about why we do not get particularly excited by short-term stock movements, please consider the implications of the preceding paragraph. After all, this single data point suggests that a great strategy for superior investing returns over the last year would have been to go out and load up on companies with horrible operating profiles. While we are certainly not above doing the occasional dumpster dive for a low-quality company that we believe trades at a meaningful discount to its fair value, we believe that Warren Buffett's advice that "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price" is something close to gospel. We believe the companies in our portfolios tend to have superior operating metrics, even if they are small (which market orthodoxy considers to be riskier), based in developing markets (ditto), and have somewhat lumpy earnings (double ditto). If the market - as it is wont to do from time to time - focuses on things other than company quality, well, we can wait. We do not believe that buying into a fad or trend -- even one built upon macroeconomic themes -- and hoping it continues, is a great basis for long-term investing success.

Not the outcome you had hoped for
Not too distant from my house in Vienna, Va., is a remarkable building at the corner of two main thoroughfares, Chain Bridge and Old Courthouse roads. The building's notable feature is a large, vertical arch framing a concave edifice. It's possible this building has an official name. Probably something insipid like "the CrossePointe TradeWindes Building," or the "EastGATE Towers West." It doesn't matter, because everyone calls this building the same thing: the "Toilet Bowl Building." It even has its own Facebook page.

(I just looked it up: it's called the "Tycon Courthouse Building." Bleh.)

This is a pretty choice piece of land, hard by Tysons Corner, the largest suburban agglomeration of office space in the United States. I'm sure back in 1983, neither the architect nor the builders nor the developers tried to build a building that looked like a giant potty. And yet, that's exactly what they managed to do.

Ultimately, the architectural theme they intended to invoke is irrelevant to the outcome they achieved. I giggle a little to imagine the first time that the developer stood before the building - probably late in its construction - and thought "is it just me, or does that kinda look like a commode?" By then, it was too late: The crime against architecture had already been committed, much to the delight of decades' worth of direction-seekers.

If I may make an awkward transition to a lesson on investing, (OK, you caught me - I really just wanted an excuse to talk about the Toilet Bowl Building) we should always be mindful that our belief of what is going to happen ex ante is often quite divorced from that which actually takes place. I always try to think in terms of "ought to."

Many investors make investing decisions with an improper balance between considering the potential returns they might generate, and the potential for loss. Few people like to think about the ways in which they might fail. But failure to consider risks in no way changes the nature of those risks. It is rare that smoking a cigarette is a fatal choice, but it is simply mathematically true that smoking increases the risk of all sorts of nasty diseases. It isn't that smoking kills 100% of the time, it's that the decision to smoke ought to lead to some nasty health consequences.

Watch out for event risks
If you think about it, a risk factor for a company may be fairly static. An investor's potential exposure to that risk factor is increased by his or her ignorance of it. Simply put, if you fail to recognize a potential risk factor for a company, you are more likely to misprice its stock. That matters because, as you may have noticed, stock prices fluctuate quite a bit, and where the stock is trading at the moment versus its intrinsic value is a key element of risk.

As an extremely severe example, in the few years preceding 2007, several hundred Chinese small-capitalization companies rushed onto the American stock markets, many through a back door methodology called a reverse merger. American investors, sensing the very real opportunity that the incredible growth that the Chinese consumer represented, plowed billions of dollars into these companies. Unfortunately, many investors failed to properly consider the potential downside to owning companies with neither a shareholder culture, nor any credible threat of punishment should they behave badly.

What very few investors -- us included -- considered, was the possibility that the Chinese government might have been complicit in these frauds. In April 2012, the SEC filed a subpoena to compel Deloitte & Touche to provide auditors documents they need to investigate fraud at Longtop Financial, a Chinese company which has -- at a bare minimum -- been found to have wildly misstated its financial results, costing American investors in excess of $1 billion. The Chinese government has forbidden Deloitte from providing these documents to the SEC under the pretext that Chinese law limits disclosure of state secrets. Never mind that Longtop apparently had no such secrets. If D&T ignores the subpoena, they're in potential violation of U.S. law. If they comply, they may be violating Chinese law.

There are two main ways investors limit exposure to "event risks." One is to own a huge number of companies, thus lowering their exposure to bad news at any one company or segment. The other -- the one we choose -- is to invest in relatively few companies and try to develop as deep an understanding of them as possible. We do not like having strangers in our portfolios -- something that would be a near inevitability were we to hold 200-300 companies in each portfolio. We believe that, as we gain familiarity with companies, our knowledge of how they work and who runs them allows us to make better, more informed decisions. It is very exciting to find a new opportunity, but if you think about it, the time that you understand something the least is when you have first encountered it! This in no way inoculates you from risks -- bad things are gonna happen. But it does improve your chance to anticipate the anticipatable and properly value the companies you own.

By the way, even if China "wins" in its attempts to shield Chinese companies against the interests of foreign investors and regulators, this win is going to be extremely costly for them. Informed investors are much less likely to buy shares in markets where they feel the deck is stacked against them and, if they do, their discount rates will be much higher. The Chinese government has successfully demonstrated to global investors that Chinese firms should, across the board, be considered much higher-risk and lower-quality than companies from other countries.

Chinese shares have dropped in spite of market conditions that would normally be extremely accommodative toward them. American and European economies have the whiff of rot and unsustainability around them, and low interest rates have pushed investors to seek growth by lowering their risk aversion in several asset classes. As a small example, former portfolio holding American Tower is preparing to issue $1 billion in debt that Standard & Poor's has rated as BBB -- (which is the lowest rating debt can receive and still be considered investment grade). American Tower is issuing this debt at 3.5%, an interest rate that would scarcely have been available to the U.S. government a few years ago. As I mentioned earlier, investors are reaching for risk. Chinese equities would be an obvious alternative. After all, China is among the largest, fastest-growing economies in the world. Instead, China's reputation for investment safety barely exceeds Russia's.

Editor's note: Bill Mann is not able to engage in discussion on the boards or in the comments section below. Bill does not own shares of any companies mentioned.

Motley Fool newsletter services have recommended buying shares of American Tower. The Motley Fool has a disclosure policy.

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