Most people prize excellence. But in all things, true excellence is difficult to find, and consistent excellence is nonexistent in many fields.
A good example is the Beatles. The band was together for only eight years, and has sold more records than any other. (Along with Michael Jackson and Elvis Presley, they are among the top in sales among former or deceased musical artists.) But out of the 275 songs they released, only 35 — fewer than 13 percent — were hits in North America. So, when using hit status (sales) on this continent as the criterion for excellence, we see that even the Fab Four did not achieve it consistently. (Neither have the Rolling Stones who, after being together for 50 years, have had 17 hits out of 439 songs.)
Inconsistent excellence is a fact of life among the top individuals in many professions, including writers, actors and salespeople. It’s also true of investment managers, who are often judged by standards of excellence that even the Beatles didn’t achieve. Investors want consistency that just doesn’t exist. They should settle for long-term averages that are pretty darned good, though these averages may be dragged down a bit by performance periods that are below hit status. In any endeavor, including the Beatles’ incredible career, the long-term average is what counts. And in many challenging endeavors where variable performance is unavoidable, down periods are inevitable.
Because it’s the long-term average that counts, the critical questions are: How often do these down periods occur and how long they last?
Davis Advisors examined the records of many investment managers widely regarded as being highly successful. This research found that, contrary to the ordinary conception that successful investment managers never underperform, they inevitably do. This study examined the long-term records of top-performing large-cap investment managers from January 2004 to December 2013. It found that about 95 percent of them fell to the bottom half of their peers for at least one three-year period, and that 73 percent ranked in the bottom quarter of their peers for at least one three-year period.
Though each of the managers in the study delivered excellent long-term returns, almost all suffered through a difficult period. Investors who recognize and prepare for the fact that short-term underperformance is inevitable — even from the best managers — may be less likely to make unnecessary and, sometimes, destructive changes to their investment plans by changing advisors. The key for these investors is to get their head around the concept that, statistically speaking, short-term underperformance isn’t a clear indicator of the prospects for long-term success.
During such doldrums, these managers might appear to be has-beens. Whether that characterization turns out to be accurate, of course, depends on whether they come out of their slumps; some do and some don’t. But many of those averaging in the top quartile for the long term have a short-term period in their past that, like most of the Beatles’ songs, isn’t a hit.
For investors shopping around for advisors, those with great long-term records who are currently in a slump might be attractive. If the chances of their climbing out of the slump look good, this might be an opportunity to get an advisor or get into a fund that might otherwise be inaccessible.
The key is to distinguish the has-beens from the likely rebounders. Look for a good 10-year record (in the top quartile of the manager’s peers), which demonstrates consistent performance over different market cycles. If they’ve been in the bottom quartile for 12 months yet have a great long-term record, that may be the time to invest with them.
If you buy a mutual fund when it’s flying high, there’s less of a chance your shares will gain much value. Plus, if you want to dump it too soon, you could get hit with tax distributions from the gains others got before you arrived. If you get in when the manager’s been in a slump long enough, you may not have these problems.
So if an advisor is truly skilled and on his or her way to a great long-term record, why is he or she down during some periods?
Sometimes it’s merely because their style of stocks — large-cap, small-cap, mid-cap, growth or value — might be out of favor with the market. If the advisor has a disciplined, repeatable process that’s rooted in quality — one that you agree with — then that advisor can do well when that style comes back into favor. So if you hire these advisors when they’re down, your long-term success may improve with theirs. Moreover, this will make your investing more interesting.
When it comes to buying stocks, applying this principle of getting shares of companies with great long-term records while they’re in a slump is the time-honored practice of value investing. Value stocks are those that the market is currently undervaluing, if only for a brief period.
Even some large, venerable companies can become value stocks for a time because they aren’t firing on all cylinders. An example is McDonald’s. Though McDonald’s has a 50-year history of good performance, the company has been selling in the low $90s range in recent weeks after a 12-month high of $104.
Another example is Target, which the market is treating like damaged goods because retail isn’t so hot right now and because of the infamous wireless breach of personal data at some stores. This is a historically well-run company that’s currently out of favor — classic value material. Over the last 12 months, Target peaked at $72. In late August, it was trading at $58.
Stocks’ coming into and going out of favor brings to mind the Byrds’ song with lyrics from the Bible: “To everything there is a season/Turn, turn, turn.” Value investors buy and await enough turns of the earth until, they hope, they’re positioned to reap gains from the resumption of good long-term performance.
The key to anticipating resumption of performance is to make sure that the investable propositions that existed before a slump still exists. If they don’t, these really weren’t value stocks in the first place because there wasn’t a sound basis for believing that they would rebound.
If a company has retained its investable proposition and diversified its markets using profits to go into new lines of business, it may be a good investment. Yet sometimes the market doesn’t give such diversification a warm welcome, and these are potential value opportunities.
An example is SWM, which has done quite well for decades producing paper and filters for cigarette manufacturers. The company’s stock declined sharply after SWM bought a big water filtration company. But, while the long-term wisdom of this move remains unproven, it may turn out to be beneficial. The short-term price depression made SWM a better buy, and its strength in its core market bodes well for price appreciation.
One way to look at it is: If a company has a current PR problem, as Target has, from a condition that’s not permanently disabling and if they’re still structured to be competitive in their industry, it could very well be a value stock. When this is clearly the case, it may be time to invest in the next possible hit.
Waiting for such stocks to rise may feel like a hard day’s night, but if and when they do, you’ll have to admit you’re feeling better – better all the time. The same goes for signing up with advisors who, though they have a history of being Lucy in the sky with diamonds, have for a short time been fixing a hole where the rain gets in.
So remember: If even the Beatles can’t be great all of the time, neither can an advisor or a stock. Instead, look at their long-term records and decide whether they still have the stuff to be fab again.
Dave Sheaff Gilreath is a founding principal of Sheaff Brock Investment Advisors LLC. He has more than 30 years of experience in the financial services industry, beginning with Bache Halsey Stuart Shields and later Morgan Stanley/Dean Witter. At Sheaff Brock, he shares responsibility for setting investment policy, asset allocation and security selection for the company's managed accounts. He also consults with the clients on portfolio construction. Gilreath received his Certified Financial Planner® (CFP) designation in 1984. He attended Miami University in Oxford, Ohio, where he earned a B.S. degree.
Any opinions expressed are solely those of the author and not of ABC News.