Applied Behavioral Finance: White Swans, Revulsion, and Value

James Montier Global Strategist Socit Gnrale Cross Asset Research London

Current market conditions, dire as they are, represent not a black swan but a predictable surprise. Unfortunately, behavioral impediments in human nature made most investors unwilling or unable to see this predictable surprise. But despite the uncertain state of todays markets, the investment environment holds many opportunities for value investors who focus on the long term.

n this presentation, I will provide a general overview of the current market, including a discussion of black swans and predictable surprises. Then, in the context of this current market, I will discuss investors behavioral biases and the psychology of bear markets.

Nature of the Market Today

One of the bizarre elements of the situation we are witnessing in financial markets today is the common perception that current volatility is both unprecedented and unpredictable. To my mind, neither of these words applies. In fact, the word unprecedented has become highly overused in our business, especially when I consider the volatility of the U.S. market going back to the 1880s, shown in Figure 1. Volatility has indeed been higher historically, so todays situation is not unprecedented. Furthermore, in the 1930s, not only was volatility higher; it remained higher. Volatility spiked at the beginning of the Great Depression and then remained exceptionally high well into the recovery. Nor is the situation unpredictable. Each of the spikes we have witnessed in volatility occurred when investors went from losing their minds at the top of the market to losing their nerve at the bottoma kind of bipolar or manic-depressive reaction to the market.
This presentation comes from the 2008 European Investment Conference: Global Strategies for Success held in Amsterdam, the Netherlands, on 24 December 2008.

Predictable Surprise vs. Black Swan. Taleb (2007) used the phrase black swans to describe unprecedented conditions. But to my mind, the conditions we are experiencing are not a black swan, which has an unusual set of characteristics. A black swan is unpredictable, it has a massive impact, and it enjoys some form of ex post rationalization so that one can think the world is much safer than it actually is. I believe, instead, that current events are much closer to what psychologists call a predictable surprise, which also has three characteristicsthe first, and most important of which, is that at least some people are aware of the problem. For example, in his second edition of Irrational Exuberance, published in 2005, Shiller included an additional chapter on the U.S. and U.K. housing markets. Even I managed in 2005 to write a note on the U.S. housing market called Pictures of a Mania? US Housing. I am not particularly well plugged into the housing markets, so the developing situation must have been fairly obvious. Second, with a predictable surprise, the problem gets worse over time, which has been a hallmark of the current environment. We have seen a slow transition from do not worry; the subprime problems are contained to oh no, they are not contained. Third, predictable surprises explode into some form of crisis, and that is certainly the stage where we now find ourselves. Behavioral Impediments to Interpreting Patterns. If the events that led to the current situation constitute a predictable surprise, one has to

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Figure 1.
30

Volatility of the U.S. Stock Market, 18852008

Monthly Standard Deviation (%)

25

20

15

10

0 1885

95

1905

15

25

35

45

55

65

75

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95

2005

Source: Based on data from G. William Schwert.

wonder why more people did not see it coming. The answer is that five behavioral impediments or mental barriers prevent us from understanding the patterns of predictable surprises. The first is overoptimism. We as a species are incredibly optimistic, and we have good evolutionary reasons to have such a characteristic. For example, early humans would never have taken on a wooly mammoth if they had not been seriously deluded about their ability to succeed. Our modern determination to marry is a similar example. Nobody gets married expecting to get divorced, despite statistics that show fairly high rates of divorce. Humans, it seems, are effectively deluded when it comes to their optimism. Second is the illusion of control: the belief that if things go wrong, we will be able to sort them out. This is the characteristic that encourages a lot of pseudoscience in finance, such as value at risk, which is a meaningless concept. The idea that we can quantify, let alone control, risk is patently absurd. Yet, the generation of a numbersuch as a 99 percent chance of a riskgives us a false sense of security, an illusion of safety. Third is the self-serving bias. Our markets are designed so that most of us do better when markets go up than when they go down. So, we do not spend a lot of time looking for bad news. Here we encounter such problems as mark to model. Mark to model is about as sensible as having me ask my students

to grade their own homework. I should not be surprised when they all give themselves 100 percent. Yet, we were perfectly willing to allow investment banks to do exactly that. Fourth is myopiaan overt focus on the short term. St. Augustine prayed, Lord, make me chaste, but not yet. Fund managers apparently pray, Lord, give me one more good year, one more good bonus, and then I promise to behave more sensibly. Fifth is the problem of change blindness, which means that we do not see the things we are not expecting to see. A classic demonstration of this phenomenon occurs in an experiment where individuals are shown a video in which two teamsone dressed in white, one dressed in blackpass a basketball among themselves. The individuals are asked to count the number of times the players in white pass the basketball to each other. Halfway through the video, a gorilla walks into camera view, beats his chest, and then walks out of view. After the video ends, the individuals are asked how many passes they counted, to which they give a reasonable count, usually ranging from 14 to 17. Then, the individuals are asked if they saw anything unusual during the video. Eighty percent of the individuals fail to notice the gorilla because that is not what they were asked to look for. They are blind to change. And change blindness has never been more relevant than it has been in the kinds of markets we are experiencing today.

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Phases of a Bubble. I recently met with a well-respected value manager in the United States. He remarked that this was the worst period he had ever lived through and that he knew this to be so because even he felt drawn to look at the market screens. Yet I contend that the events we are experiencing are actually quite standard. They represent a transition through the phases of a bubble, and I tend to perceive bubbles through the framework of ideas developed by such theorists as Hyman Minsky and Charles Kindleberger. I have simplified the framework to five stages, of which the last three are of particular interest: 1. 2. 3. 4. 5. displacement, credit creation, euphoria, critical stage/financial distress, and revulsion.

Euphoria is the madness stage when everybody believes that a new, better era has dawned and valuation measures creep up the income statement. But the dawn proves to be a false one, and euphoria gives way to financial distress. This is the critical stage when troubles become apparent. Insiders cash out, and everyone can see the problem. Finally comes revulsion, which is heaven for the value investor. This is the stage when asset prices are unambiguously cheap, which is the primary characteristic of revulsion. It is also the stage when investment professionals become embarrassed to admit they work in finance. Revulsion toward bonds. How close are we now to revulsion? The answer at this time varies by Figure 2.
Basis Points 800 700 600 500 400 300 200 100 0 25 31 37 43 49 55 61

asset class. The asset class closest to outright revulsion is corporate fixed income. The spread of BAA bonds over U.S. Treasuries currently stands at 550 bps. At the height of the Great Depression, the spread was 700 bps, as shown in Figure 2. The markets are thus approaching the same level as back then. Default rates remain low, but given the implied spread and the fact that defaults lag actual conditions, I expect a default rate across all grades of perhaps 7 percent, which is pricing similar to the environment of 1931. So, fixed income may be in the worst situation since the 1930s, but the debt markets are already pricing that fact in. I can find examples of senior secured debt trading at 5070 cents on the dollar, which is incredibly attractive because I am highly likely to get a full dollar back on that investment, even in the event of liquidation. Yet, most people will not touch it. Revulsion toward stocks. Equities have not yet reached revulsion, although we are close, and I am much more optimistic than I have been in a long time. When I consider valuation from a topdown perspective, I tend to use the Graham and Dodd P/E, so price is relative to a 10-year moving average of as-reported earnings, shown in Figure 3. I use this series because Graham recommended it when he and Dodd wrote Security Analysis in 1934. They said that using P/E is fine but that it should be used with a moving average of at least 5 years, preferably 10. It is a simple way of smoothing out the business cycle. And it shows that equities are currently trading just below multiples of 15, which is not bad. The average since

Spread of BAA Bonds over U.S. Treasuries, 19252008

67

73

79

85

91

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03

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Figure 3.
P/E 60 50 40 30 20 10 0 1881

Graham and Dodd P/E, 18812008

89

98

1907

16

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34

42

51

60

69

78

87

95

2004

Source: Based on data from Socit Gnrale Equity Research.

1881 is 18. If I strip out the bubble, the average is 16 times. But those are not bargain basement multiples. Bargain basement is 10 times, which occurs when the S&P 500 Index is around 500. In the 1930s, this measure got down to five times, which is equivalent to the S&P 500 trading at 250. I am not suggesting that the S&P 500 will go to 250. I am not even suggesting it will go to 500 necessarily, but that would be the range of serious bear markets in previous cycles. The good news is that the United States is not home to the only equity market in the world. Alternatives do exist. But even from the U.S. perspective, we can see that the U.S. market is on the more attractive side of returns because valuations are never a binding restraint in the short term. Expensive markets can always get more expensive; cheap markets can always get cheaper. But valuation is the primary determinant of long-term return; therefore, from a long-term investors perspective, the U.S. market looks, in aggregate, vaguely attractive. In contrast, the United Kingdom and Europe are approaching bargain basement levels. For example, the Graham and Dodd P/E in the United Kingdom is at 12 times. Therefore, long-term investors can potentially find attractive returns in the U.K. and the European markets. Graham Valuation Criteria. Although discussing valuations from the top down can be interesting, a much more informative perspective comes from the bottom up. To look at valuations in this manner, I use a series of 10 criteriato which I have attached an additional hurdlethat Graham designed in 1976, shown in Table 1. Even Graham,

however, realized few stocks would pass all criteria, so his favorite was Criterion 5, which is a stock price of less than two-thirds of net current asset value. Not many large-cap stocks trade below two-thirds of net current asset value, but the number grows among small caps. In Japan, I can find an overwhelming number of small caps now trading at this kind of valuation level. But Graham said that if stocks are not trading below two-thirds of net current asset value, then consider Criteria 1, 3, and 6. Criterion 1 is an earnings yield that is at least twice the AAA bond yield. Criterion 3 is a dividend yield that is at least twothirds the AAA bond yield. Criterion 6 is total debt less than two-thirds of tangible book value. So, Graham was urging investors to find stocks that were cheap, that were still returning cash, and that were not likely to go bust. To do that, I add one extra criterion: I require the stock to have a Graham and Dodd P/E of less than 16 times, and I do so to rule out cyclicals, stocks that are potentially cheap only because they have had massive peak earnings. I chose 16 times because that is what Graham said is the maximum price one should pay for an investment; anything above that is speculation. Therefore, when I use these four criteria, I find that about 2 percent of stocks in the S&P 500 pass the criteria. In Europe and the United Kingdom, roughly 10 percent of stocks pass the test, and in Japan and Asia, approximately 20 percent of stocks pass. Potentially, therefore, I am finding incredible bottom-up value opportunities. Had anyone told me in 2000 that I, as a value investor, would recommend that clients buy Nokia, I would not have

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Table 1.
Criteria 1 2 3 4 5 6 7 8 9 10 11 12

Percentage of Stocks Passing the Graham Valuation Criteria

United States 37% 9 33 3 1 38 28 20 69 5 3 2 Europe 53% 10 67 6 0 39 15 17 67 8 14 8 United Kingdom 53% 17 65 11 3 43 21 25 49 15 12 7 Japan 78% 5 83 20 0 69 24 36 68 6 47 20 Asia 63% 12 61 19 0 73 27 27 78 11 33 17

Earnings yield > (2 AAA yield) P/E < 40% of peak P/E Dividend yield > 2/3 of AAA yield Price < 2/3 of tangible book value Price < 2/3 of net current asset value Total debt < 2/3 of tangible book value Current ratio > 2 Total debt d 2 net current asset value Compound annual growth rate t 7% over 10 years Two or fewer earnings declines of 5% Passing 1, 3, 6 1, 3, 6, and Graham and Dodd P/E < 16

believed it. Yet Nokia now passes Criteria 1, 3, and 6 and has a Graham and Dodd P/E of less than 16 times. So, I am finding world-class companies at bargain basement prices, and that to me is the definition of investment heaven. C Score and Shorting. Although I can find a lot of stocks that I would like to go long, I can find very few that I would like to go short. Earlier this year, I created something called the C scorefor cooking the booksthat measures companies on their use of six accounting techniques commonly used to mislead investors: a growing difference between net income and cash flow; an increasing days sales outstanding; a growing days sales of inventory; increasing other current assets to revenues; declines in depreciation relative to gross property, plant, and equipment; and total asset growth of greater than 10 percent. When I combined the C score with a measure of valuation, I found that the C score provided a particularly impressive means of finding shorts. In May 2008, the largest number of U.S. stocks I had ever seen were passing this test. Europe was also at high, although not record, levels. Today, because of the markets decline, only a handful of companies are passing this test. Therefore, I am finding very little to short, which should appeal to the valueoriented bias that we all should have when investing (at least ex financials). Why Investors Shun Value. Curiously, investors shun value, and they do so for myriad reasonsmany of them related to the design of the human brain. Consider the following example of the human bias against value. It comes from an experiment done by Dan Ariely, which he describes in his recent book Predictably Irrational. It has nothing to do with finance but everything to do with

human nature, which is, of course, at the very heart of finance. Ariely asked people to sample several bottles of wine with values of $5, $10, $35, $45, and $90 per bottle. When the participants were asked to rank the wine by taste, they ranked the $10 wine quite poorly compared with the $90 wine. But then it was revealed that the $10 bottle and the $90 bottle contained the same wine. People were allowing price to be a major influence on their perception. Such biases in human behavior create a fundamental challenge for economics because economic thinking tends to assume that people know their own preferences. Yet Arielys wine experiment demonstrates that preferences are unstable and vary according to arbitrary inputs, such as price. Value Investing and Current Risk. Despite my assertions that the current environment is an excellent one for value investing, I am well aware that the world is not a riskless place. Many issues face us. After all, we do not know how bad the economy will get. This recession could be truly horrific. It could be the worst since the 1930s. For example, consider the S&P 500 earnings cycle. Figure 4 shows that when measured from peak to peak or from trough to trough during the course of a full cycle, U.S. earnings have never grown by more than 6 percent a year. Early in 2008, U.S. markets were at the very top edge of the 6 percent band; now, they are near the bottom edge of the band. That, unfortunately, does not indicate that the earnings cycle is complete because the move from the top edge to the bottom edge was driven purely by financial stocks. If I were to build this series without financials, the cycle would still be at the top edge of the band, which means that a lot of earnings risk remains. Therefore, the earnings cycle could turn out to be truly abysmal. If I next impose the valuation experience of the 1930s onto current conditions, the result is something like that shown in Figure 5. In this figure, I charted the S&P 500 earnings from 1997 to the present

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Figure 4.
5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0 50 54

S&P 500 Earnings Cycles, 19502008

Log S&P 500 Earnings

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Figure 5.
90 80 70 60 50 40 30 20 10 97

S&P 500 Earnings, 19972011

Total Earnings per Share of S&P 500

If the 1930s experience is applied to future periods

99

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07

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11

(marked by the vertical line), at which point I applied the experience from the Great Depression. Up to the current date, earnings have halved, which is exactly what happened from 1929 to 1930. Thereafter, earnings halved again, and that is the behavior that drags valuation down to those 10 times and 5 times levels that the Graham and Dodd P/E measures. Long-term investors should not care about such falling valuations. But in a world of myopic human behavior, a large proportion of investors will see only the near-term outlook and will act in a way that drags their stocks lower. I am not suggesting, however, that investors should not buy the value opportunities currently available. After all, value investing is all about being humble, and all value investors should keep a margin of safety in the forefront of their thoughts. That

margin of safety is at the heart of value investing. It gives value investors the prerogative of being wrong; it is why value investing works. Consider a comparison of cheap and expensive stocks (or value and glamour) and the ranges in their growth from highest to lowest, shown in Table 2. If I had bought the value stocks that went on to deliver the highest growth, I would have generated an annual return of about 20 percent. But even the value stocks that delivered the lowest growth would still have generated about a 12 percent annual return. If, however, I had bought the glamour stocks, the most expensive ones that everybody loves, even at the highest possible growth, they would have delivered no more than 8 percent annually, and the lowest growth glamour stocks would have generated little more than 2 percent.

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Table 2.

Stock Returns Split by Annual Earnings Performance: Developed Markets, 19852007

Quintile Highest Growth 19.8% 20.6 17.8 15.7 7.90 Lowest Growth 11.9% 10.9 8.10 6.12 2.18

Category Value 2 3 4 Glamour

2 21.6% 18.0 14.0 10.5 5.04

3 17.7% 13.7 11.6 8.55 4.42

4 15.9% 11.0 9.87 6.67 2.77

Source: Based on data from Socit Gnrale Equity Research.

Typically, therefore, value investing affords room for mistakes. This year, however, we have not had that cushion. Value has suffered disproportionately, and the reason is indiscriminate selling. Year to date, the cheapest stocks globally based on Graham and Dodd P/Es are down about 45 percent, whereas the most expensive stocks are down about 40 percent. Such behavior indicates forced selling, regardless of value, and that situation creates opportunities for value investors. The last time such a situation prevailed was in the United Kingdom in 2003, when many pension funds were being required by their actuarial advisers to dump their equities. That was a compellingly attractive situation for value investors like me. But the situation in 2003 pales in comparison with the appalling, indiscriminate performance witnessed during the Great Depression. A common misperception is that during the Great Depression, value stocks significantly underperformed the rest of the market. But that is not true. According to the Fama and French data, from 1929 until the market trough in May 1932, value stocks lost about 38 percent annually, but so did glamour stocks and the market overall. The advantage for value investors was that when the reflationary policies began to work in 1932, value stocks rebounded much more quickly than glamour stocks did. Based on this analysis of the current situation, I would argue that a sensible investment strategy right now would include at least three prongscash and deep value opportunities and sources of cheap insurance. If reflationary policies begin to workand I have no idea whether they willthen value stocks will be the most likely beneficiaries when the rebound occurs.

Psychology of Bear Markets

Many of the same biases that drive bull markets also drive bear markets. That is, the same kind of overextrapolation also occurs during the revulsion phase. But one factor is far more dominant during bear markets than during bull marketsemotion.

Effect of Fear on Investment Behavior. T h e human brain is wired such that emotion has primacy over rational thought. Our emotions, particularly the emotion of fear, are designed to win, which makes sense, especially from an evolutionary perspective because the cost of a false positive caused by fear is fairly low. For example, if I see a coiled piece of rope and give it a wide berth on the off chance that it might be a snake (a false positive), I have lost little in my decision. If I assume, however, that the coiled object is a rope and then discover (when I decide to step over it) that it is a snake (that is, a false negative), then the harm can be irreparable. The payoff is not symmetrical. Unfortunately, the warning system of fear that evolved to keep us out of trouble on the African savanna is less beneficial when applied in the context of financial markets. Consider how fear guides human behavior in the following experiment, which is a game lasting 20 rounds. At the beginning of the game, each participant is given $20. At the beginning of each round, participants can choose whether or not to invest $1. A fair coin is then tossed. If it comes up heads, each of those who chose to invest receives $2.50. If it comes up tails, each investor loses the $1 invested. Two things are known about the game. First, the payoff is not symmetrical, so it is optimal to invest in all rounds. Second, the coin has no memory, so the outcome of a previous round will not affect the outcome of a succeeding round and, therefore, should not affect anyones decision to invest from round to round. Yet, data from this experiment show that individuals with a normal fear system invest less than 50 percent of the time after a round in which they suffered a loss. Furthermore, the longer the experiment lasts, the more timid the participants become. Fewer and fewer are willing to invest. They are learning the opposite of the lesson they should be learning. Such is the influence of emotions over rational thought. Similarly, in the actual world of finance, the more often investors check their portfolios, the more likely they are to see a loss because volatility will become more obvious. These losses trigger the fear system, so the longer investors find themselves in these conditions, the poorer their decision making actually becomes. Sir John Templeton emphasized the importance of buying at the point of maximum pessimism. But he also had a tactic for dealing with the human fear system. He did his analysis of intrinsic value on days when the market was fine. He would then submit an order to his broker with a fill price (perhaps down 50 percent) and then forget about it. If the market happened to fall or that particular stock fell and his order was filled, he was delighted. But

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he had to commit to such a purchase ahead of time because he knew that he would probably not have the nerve to purchase that stock on the day it was down 50 percent. So, precommitment can help one attain emotional distance. Value of Long-Term Investing. Earnings may drop significantly during the next few years, but that should not matter to a long-term investor because equities are inherently a long-duration asset. They are a claim on long-term future cash flows. I recently conducted an exercise using DCF (discounted cash flow) analysis. More specifically, it was a DDM (dividend discount model). Even though DCF is, theoretically at least, the only correct way to value equity, I dislike it because it is so difficult to implement. As one firm aptly pointed out, DCF is the investment equivalent of the Hubble telescope: Move it an inch, and it ends up in a different galaxy. Nevertheless, I constructed a DDM for the U.S. market and found that only 10 percent of the value of the S&P 500 is derived from the succeeding three years of activity. Even adding in the next five years of activity provides no more than another 15 percent of the value. In fact, 75 percent of the value comes from the long term, that is, the period beyond which I was modeling. My conclusion is that the vast majority of my return is driven by long-term earnings power. Therefore, investors should not obsess about short-term results. Unfortunately, that is exactly what they do. In fact, investors today have a chronic case of attention deficit/hyperactivity disorder. Figure 6.

They make my three-year-old nephew look like he has a seriously long attention span. Investors today seem incapable of looking beyond the next quarter or two. The average holding period for a stock on the New York Stock Exchange today is seven months, as illustrated in Figure 6. In 1940, it was 10 years. Even in the 1970s, it was six years. But with a seven-month horizon, the only thing that matters is the next quarter, which means that the market has become an earnings junkie. Investors are hooked on who is going to make or beat their quarterly expectations. Such behavior is speculation, not investing. As a fundamental investor, my ability to understand improves as my time horizon extends. For example, consider contributions to total return. With a one-year time horizon, about 28 percent of total return comes from dividend yield and about 12 percent comes from growth in real dividends. Thus, about 60 percent is generated by changes in valuation, which are, in essence, random changes in prices that few, if any, investors can predict. When I extend my time horizon to five years, however, the factors I can understand have a greater impact on total return. Dividend yield and the growth in real dividends account for about 80 percent of total return over five years, and those relatively unpredictable changes in valuations account for only 20 percent of total return. Thus, as investors extend their time horizon, their ability to understand improves. In fact, the long term is the only thing that investors can hope to understand.

Average Holding Period of a Stock on the New York Stock Exchange, 19202008

Holding Period (years) 10 9 8 7 6 5 4 3 2 1 0 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05

Source: Based on data from the NYSE.

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Sources of Cheap Insurance. The final element of survival in conditions such as the present is cheap insurance, which refers back to the belief that investing should be a humble process. Investors should be realistic about the limits of their understanding. They will make mistakes, so they need protection when those mistakes occur. Right now, the area of greatest concern to me is the debate over inflation and deflationthat is, which of these two is likely to dominate the current recession. If I anticipate a period of U.S. debt retrenchment and consumer retrenchment for the first time in a quarter of a century, I can easily foresee a period that is enormously deflationary. But if the U.S. Federal Reserve and the U.S. government continue to apply a strong fiscal and monetary policy response, I can only assume that inflation will occur. Therefore, because I am uncertain whether inflation or deflation will dominate, I need to find some cheap insurance. Fortunately, two groups of assets currently offer such insurance: index-linked bonds and gold. In the United States, TIPS (Treasury InflationProtected Securities) currently offer a 4 percent inflation-adjusted yield. That is a real return of 4 percent. If deflation occurs, my principal is unaffected. In Europe, French index-linked bonds are yielding nearly 3 percent, and those issued in the United Kingdom are yielding about 2 percent. The other cheap source of insurance is gold, which is an excellent hedge against inflation. And in the event of financial Armageddon, it is a real physical asset. Short-Term Results and Performance Measurement. Unfortunately, the tragedy of following the advice I have offered is that it will get most fund managers fired. Why? Because we insist on measuring performance in the short term. I know some fund managers who watch the performance of their portfolios throughout the day. I cannot imagine any worse behavior. Recently, the Brandes Institute studied the top decile of fund managers over a single decade. The study identified these top managers worst single year and their worst three-year performance in that single decade. In their worst single year, they were

about 20 percent behind their benchmarks. In their worst three-year period, they were about 9 percent behind their benchmarks. The lesson I take from this study is that underperformance is an unfortunate by-product of a sensible investment strategy. Managers who do the right thing in the long term will, by the very nature of the strategy, get things wrong in the short term. Unfortunately, managers are fired for what they do in the short term. Goyal and Wahal (2008) published an excellent study of the hiring and firing decisions made by institutional pension funds. Figure 7 shows some of their findings. Note that Time 0 is the time when a decision is made to hire or fire. The bars to the left of 0 indicate the managers performance before the hiring and firing decisions. As the figure indicates, managers who were hired did quite well in the past, with returns reaching nearly 15 percent three years previous to Time 0. In contrast, the managers who were fired did rather poorly in the past, with returns around 5 percent. But look at the results to the right of Time 0. The managers who were hired, who had shown such stellar performance in the recent past, now do no better than average. And the managers who were fired go on to do remarkably well. It appears, therefore, that managers are fired at just the wrong point in the cycle and that basing decisions on short-term results is shortsighted and counterproductive.

Conclusion
Current economic conditions represent a predictable surprise that has numerous precedents in the history of financial markets. Unfortunately, certain human characteristicssuch as a tendency toward optimism and a blindness to the unexpectedmake it difficult to anticipate even predictable surprises. Once such a predictable surprise occurs and markets fall, another behavioral characteristic (fear) makes it difficult for investors to make sound investment decisions. They tend to focus on shortterm rather than long-term results, yet it is in the long term where the greatest value can be found.
This article qualifies for 0.5 CE credits.

R EFERENCES
Ariely, Dan. 2008. Predictably Irrational: The Hidden Forces That Shape Our Decisions. New York: Harper Collins. Goyal, Amit, and Sunil Wahal. 2008. The Selection and Termination of Investment Management Firms by Plan Sponsors. Journal of Finance, vol. 63, no. 4 (August):18051847. Montier, James. 2005. Pictures of a Mania? US Housing. John Mauldins Weekly E-Letter (4 July). Shiller, Robert J. 2005. Irrational Exuberance. 2nd ed. Princeton, NJ: Princeton University Press. Taleb, Nassim. 2007. The Black Swan: The Impact of the Highly Improbable. New York: Random House.

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Figure 7.
Return (%) 15

Performance of Investment Management Firms before and after Hiring and Firing

10

10

3 to 0

2 to 0

1 to 0

0 Time (years) Hired Fired

0 to 1

0 to 2

0 to 3

Note: Time 0 is the point when a decision to hire or fire is made. Source: Based on information in Goyal and Wahal (2008).

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Question and Answer Session

James Montier
Question: To what degree is adhering to policy portfolio guidelines contributing to the market sell-off? Would a less constrained investor have the same need to sell in a falling market? Montier: Investing should be unconstrained. The very process of investing should allow me to exploit whatever opportunities I can find, wherever they may be. So, I do not understand why investors want to constrain managers. I have long thought a flexible approach to policy benchmarks would be much more sensible, particularly because we know that in the long term, valuation dominates returns. Therefore, my policy benchmark should change, depending on the kind of valuation environment I find myself in. In 2000, for instance, I would have had a very low equity weighting because equities were enormously expensive. Today, I would have a much higher equity weighting because they are becoming cheaper. Pension consultants have a lot to answer for in this context. In the United Kingdom, actuaries have been telling pension funds they should be switching into bonds at just the wrong point in the cycle. The last time they told them to do that was 2003. So, it appears to me that the actuaries and the consultants who help set these policy benchmarks have an incredibly tenuous grasp on the reality of investing. Question: Does your statement that risk cannot be quantified contradict your other statement that volatility is predictable? Montier: Fair point. The answer is yes and no. The way I resolve that conundrum is by assuming that volatility does not define risk. Being a student of Ben Graham, I believe that risk is the permanent loss of capital, not random price fluctuations. The volatility regime is inherently predictable, but I do not believe volatility is a meaningful measure of risk. Question: Do you think prohibitions on short sales are necessary or constructive? Montier: Most definitely not. I believe that short sellers are much closer to being the accounting police than anyone else around today. That was a job that used to be done by the Financial Accounting Standards Board and the U.S. SEC, but neither of them seems to want to do the job anymore. Short sellers, therefore, are among the most fundamental investors I know. In fact, the largest short fund in the world has an average holding period of a year, which is not bad for a short seller. You certainly cannot accuse them of being momentum players. I think, therefore, that the restrictions are meaningless. The idea that prohibiting short selling solves the problem is demonstratively wrong. After all, markets continue to decline. If shorting were the cause of the problem, we would all be short sellers because it would be the easiest way to make money. It seems a shame to think that China and Japan are more committed to free market policies than the United Kingdom and the United States, but neither China nor Japan has outlawed short selling. Personally, I suspect that the United Kingdom and the United States are going down the same road that Pakistan went down. First, Pakistani authorities banned short selling. When the market then fell another 25 percent, the authorities then decided it was illegal for stocks to go down. Question: Is a dangerous bubble developing in U.S. Treasury securities? Will that be the next black swan? Montier: Potentially, yes. The outcome hinges on the time horizon, as do all bubbles. If deflation is the outcome, then the odds are the pricing of U.S. Treasuries is perfectly justifiable. If, in contrast, inflation wins out, then no one wants to be holding Treasuries at 2.75 percent. That is why I prefer inflation-indexed bonds over conventionals in this environment. Furthermore, they provide more yield, which makes no real sense unless we are in absolute deflation. So, yes, one could argue that there is a high degree of value risk in the U.S. Treasuries market. Certainly, when Fed Chairman Bernanke spoke on monetization and unconventional measures, he clearly stated that the Fed would be willing to buy bonds along the curve as outright monetization. If that were to occur, I would not want to be the last investor holding bonds because if such a policy is successful, then it leads to nothing other than high inflation. From a long-term perspective, one would not want to be allocating large amounts of cash to U.S. Treasuries right now. Question: If human beings are designed to follow the crowd, is there any likelihood of change in our behavior? Montier: I recently reread Galbraiths A Short History of Financial Speculation. It was a recent edition that includes the forewords from

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earlier editions. In the early forewords, Galbraith wrote longingly of being able to educate people. In the most recent foreword, he noted that he had given up on educating people. He said he was grateful that bubbles kept happening because they kept making him rich. Every time they burst, people would flock to the store and buy his book. Sadly, I think there is little chance we can eradicate the behavioral biases that drive us toward boom and bust. But such biases certainly make investment that much more fun. If markets were stable, our lives would be incredibly dull, and our industry would not sustain the numbers it currently sustains. It is worth noting, however, that the brain has evolved over an incredibly long period and is actually best designed to deal with the African savanna of 150,000 years ago, not the modern financial world in which we play today. Evolutionary changes occur at a glacial pace, but they do occur. So, perhaps one dayin another 150,000 years or soour brains will finally wake up to the idea that fear is not a valuable characteristic in financial markets. But you and I will not be around to see that change. Question: Do range-bound markets, such as those that occurred from 1968 to 1982, change the way you would invest? Montier: In equity evaluation terms, two things happen. Overvaluation can be corrected in one of two wayseither prices decline and restore valuation and higher returns occur in the future, or there begins a long period of sideways drift, during which time multiples go nowhere and earnings slowly rebuild valuation support. Historically, we have seen both, and quite often, after a serious bear market, we see a period of neglect.

The revulsion phase is characterized by investors showing an extended lack of interest, so assets remain cheap for a considerable period of time. Perhaps one of the best indications that we may not yet be in revulsion is that investors keep trying to find the bottom. When investors stop trying to find the bottom, then you can be certain that we have reached revulsion. I certainly agree with Vitaliy Katsenelson, who wrote Active Value Investing, which is all about range-bound markets. These environments are very challenging and may require a slightly shorter-term focus. But I am not convinced. Certainly, the evidence shows that value does just as well during range-bound markets as it does during big bull markets, so such conditions do not change the way I invest. It just means that returns are generated in a different fashion. Question: In measuring returns to value, how do you account for the lower liquidity of value stocks, which are often small caps with a higher rate of business failure? Montier: Keynes once described liquidity as the most unpleasant of social fetishes. I have a great deal of respect for his words. Every time I publish a note with a list of value stocks in it, Socit Gnrales derivatives arm invariably writes to me and says, Great idea, but can we have some moreliquid stocks? My answer is invariably unprintable. As a long-term investor, I do not care about liquidity any more than I care about volatility. It is an irrelevance that people get hung up on. Yes, it is certainly true that the highest business failure rate occurs among value stocks. But that is one of the reasons that value does better over time, because value investors are taking an additional risk. But that risk is more than compensated for, so I have little problem with the fact that I

am buying what may appear to be riskier businesses, although I am not so sure that they are riskier from an investment perspective. For example, I have studied net current asset value plays, which are inherently small-cap, illiquid stocks. The failure rate among such stocks is 9 percent, compared with about 5 percent in the market overall. But the value stocks generated 35 percent per annum against 12 or 13 percent for the overall market. So, I was getting quite a lot of compensation for bearing a relatively small increment of risk. I am, therefore, relatively happy with the sort of illiquidity and business risk that I run. Question: Does the amount of forced selling from loan calls, fund closures, and so forth make this market different enough to call it a black swan? Montier: I am not convinced that we are seeing a black swan. The fact that there was too much leverage in the system was not particularly hard to see. In August 2007, I wrote some fairly scathing words about a few hedge funds, pointing out that running a value strategy with seven times leverage was pure stupidity. Thats straight out of Keynes. In fact, almost everything worth saying about investing has already been said by either Benjamin Graham or John Maynard Keynes. In 1934, Keynes pointed out that if investors intend to follow a value strategy, they should not do so with borrowed money. If value stocks carry greater risk (or volatility at least), then the investor should not carry a lot of leverage. When investment banks go from being 5 times leveraged to 30 or 40 times leveraged, it is not difficult to foresee problems. So, the leverage argument does not convince me that this is a black swan. I still believe it was a predictable surprise.

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Question: Are stocks now passing the value screen that would not have done so in the past? Montier: Yes, absolutely. For the most part, value investors are a fairly homogeneous lot. We usually agree on what to buy or sell. But this year we have been unusually divided. One camp has been buying financials; the other camp has been selling financials. Ive been in the latter camp. I exclude financials because I see no margin of safety in them. When I examine the balance sheet of a financial, all I see is a very thin sliver of shareholder equity on top of a huge mountain of liabilities set against an asset side that is completely unknown. The risk of permanent loss of capital in that scenario seems enormous to me, especially when capital keeps getting diluted at the rate of 2540 percent per annum, which has happened in the United Kingdom. So, I strip out financials. The other group of stocks that keeps appearing on the value screen despite the anticyclical filter contains oil stocks such as Chevron, BP, and ConocoPhilips. Although these stocks have been hit hard as oil prices fell, I am quite happy to buy them. An assortment of other stocks that I had never thought would appear on my value screens is now appearing, and that is just fabulous. Question: How are you approaching investing for people who do not have a long-term horizon at this pointpeople in their 70s whose pension assets have been hit badly? Montier: For those who find themselves in the unfortunate

position of having a retirement pot thats just shrunk rather dramatically, the best they will be able to do is to look for assets that offer a reasonable return in real terms, such as short-maturity TIPS. I would also advise them to buy some reflation hedges, which would consist of deep value stocks, because if the reflationary efforts of the authorities are successful, those will be the stocks that rebound fastest. So, I still think there are opportunities even for those who are suffering the decline of their retirement savings to perhaps recoup some of those losses. Question: Why are TIPS yielding such an attractive rate, and will those be traded out now that you have drawn our attention to it? Montier: I have no idea why TIPS are yielding what they are yielding, and I have given the issue quite a lot of thought. You will notice that the spike in TIPS is relatively recentwithin the last two months. The only thing I can think of that would cause that is forced selling of TIPS and a flight to liquidity because TIPS are certainly not as liquid as their conventional counterpart. But given my previous comments on liquidity, you know Im not particularly worried about that. I am also not particularly sure I would want to buy credit default swap insurance on default by the U.S. government. After all, it owns the printing press. Even Brazil can repay its own locally denominated bonds. So, it seems to me that some oddities are appearing in markets that may have something to

do with forced selling of assets, and that creates the opportunity. Another possible explanation is that the market thinks deflation is more likely than inflation, at least in the near term, so it is buying conventional bonds rather than TIPS. This does not make sense to me because TIPS have a deflation clause, so they might as well hold their TIPS, but it is a plausible explanation. Question: What is your current evaluation of the European junk bond markets? Montier: Across all spectrums of corporate bonds, I can find yields that look attractive. I do not know what European junk is yielding now, but I have seen some in the United States that are yielding upwards of 24 percent, which must be pricing in at an enormous default rate. So, I suppose that Europe looks fairly similar. I see that level of fear and revulsion as a perfect opportunity, provided the manager can deal with advisers warning that such investments are illiquid, which, as you know, does not trouble me. To my mind, anything that offers an attractive yield in this environment is a perfectly sound investment, provided one has done the fundamental analysis and can tell the difference between quality junk and nonquality junk, which is outside my knowledge base but is well within that of specialist investors. Investors in the United States who specialize in distressed debt are facing the best opportunities they have ever had, and I see no reason why that would be any different in Europe.

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