Modern Portfolio Theory says we must accept more risk to get a higher return. Risk and return go hand in hand according to this theory.
We disagree.
Some investment practices do cause risk to increase with returns. Leverage is classic. Using debt to partially fund an investment portfolio accentuates the returns to equity investors, both up and down. The greater the leverage, the greater the equity return if things go well and the greater the loss if things don’t go so well.
In the specific case of using debt to fund an investment portfolio, we agree. Using leverage links risk and return, just as the Modern Portfolio Theory assumes.
Leverage does other nasty stuff to investment portfolios. When things go bad in the economy and stock prices plunge, lenders will likely either want their money back or demand more collateral. Investment managers that use leverage to goose returns then must sell stocks to raise liquidity. They are forced to sell stocks when they should be buying. We like to do the opposite.
We don’t use debt in our portfolio for that very reason. By not using leverage, we position ourselves to buy stocks when they go on sale.
But not all portfolio management practices create that positive correlation between risk and return. Some portfolio management practices, if implemented properly, create the opposite relationship. They create higher returns with lower risk. Buying stocks at prices below their underlying value is one of them.
Consider two stocks. Each has an underlying value of $100 per share. One trades at $50 per share and the other at $150 per share. The former has lower risk with higher potential returns than the latter, provided the prices of each stock move to their long-term values over time.
But, do businesses that are worth $100 ever sell for $50 in the market? And, do those stocks revert to their underlying value over time? We think the answers to both questions are, yes.
Warren Buffett bought his first shares of GEICO sometime in the late 1970s. His average cost was $6.67/share. Seven years later, the company generated about $9/share in after-tax operating profit. Buffett, in other words, bought GEICO for less than 1x earnings seven years out.
Buffett bought shares of Coca Cola in 1988 for about 5x earnings seven years out. He bought Apple stock in early 2016 for about 4X earnings seven years out.
You might wonder how a guy like Buffett spots those little gems in the rough and buys them prior to substantial earnings increases that are not discounted in the price of the stock, but one thing you cannot question is the market sometimes offers spectacular businesses at bargain prices.
Coca Cola, Geico, and Apple are each among the best business franchises in history. Buffett bought each of them for less then 5-times earnings seven years out. Equivalent businesses today trade for 20 to 30 times earnings. The market, in other words, put prices on these great franchises that were substantially below their underlying values. The prices of each eventually moved toward their underlying value, creating three of the best investments in the history of stock selection. All remarkably made by one person sitting at his desk reading 10Ks.
A portfolio of these types of businesses produces higher returns with lower risk than a portfolio of overvalued businesses. It is that simple.
We reject the notion that higher returns require higher risk. It simply isn’t true.
