Piet Viljoen’s Value Investing 101: Beat the market with a margin of safety – and by ignoring “stories”

Piet Viljoen is one of the most rational people I know. And he is a good friend. I first engaged with him a couple decades back. The unit trust he then managed, the Investec

Piet Viljoen: The "genuine" value investor is able to turn away from stories
Piet Viljoen: “Genuine” value investora turn away from the narrative, the “stories”

Opportunities Fund, performed much better than its its direct competitors. I wanted to know how he did it. And discovered a young man who thought differently, elevated facts above opinion and had the courage of his convictions. We hit it off and kept in touch over the years. Including spending time on the annual pilgrimage to Omaha for the Warren and Charlie Show (Piet being the first person to suggest that Charlie Munger, rather than Buffett, is the “brains” of the Berkshire Hathaway outfit). But it was a conversation we had during a walk along the Swan River in Perth in early 2002 that influenced me most. I was in the Western Australian capital on an unofficial “look see”. The business I had started was sufficiently profitable and well enough capitalised to consider expanding into Australia. I went over with colleague Stewart Bailey for six weeks to establish a base for Mineweb in Perth, and investigate a potential acquisition of a Moneyweb-lookalike in Sydney. When Piet stopped by en route to the watching the Proteas, my enthusiasm for Australia (and pessimism about SA) was at an all time peak. The Rand was in freefall, the A2 banking crisis at its zenith, and calm Australia looked a far better proposition than my turbulent homeland. For the first and only time in my life, I seriously considered emigrating. It was the walk with Piet that changed my mind. Not long afterwards, he put his money behind his own views by taking the ultimate bet on South Africa. He left a great job at Investec to start Re:CM based on a conviction that SA was hugely undervalued and it was time to “buy local stocks.”  Ten years later, Re:CM is one of the country’s most respected asset managers. And Piet Viljoen among the most recognisable names in his field. Yesterday he opened Re:CM’s annual Johannesburg conference with a superb talk about the hidden danger stories hold for investors. Here is an edited copy. It could also have been entitled: Value investing 101. Or, the Piet Viljoen Way.  – AH    

By Piet Viljoen*

How many times have you been in a meeting where all the evidence points in one direction, and then someone offers up an anecdotal counterexample. Like:  “You want to quit smoking? Why? My grandfather smoked a pack a day, and he lived to the age of 92.” That’s all it takes – meeting over, end of story. This simple anecdote now has everyone ignoring the evidence and statistical distribution. And focusing on the grandfather.

Stories don’t encourage us to think. They make it easy to overlook evidence, fall prey to cognitive biases and generally encourage bad decisions. As investors we need to question everything, and train ourselves to think deeply. Stories get in the way of this. So how do genuine value investors deal with a world where perception is reality, and where perception is influenced by the stories we tell each other?

Because over the long term, it works. Value investing outperforms. And it outperforms because you get some of the upside with a lot less of the downside. Our clients understand how compounding works, and therefore understand how powerful it is to lose less when the going gets tough, even if you make less when the going is good.

Value investors have another identifiable edge, which is even harder to copy than the psychological edge we have. That edge is called MARGIN OF SAFETY. Those of you who run businesses will understand that the possession of an edge over your competition is valuable, and if the competition can’t copy that edge, it is invaluable.

The reason why there are so few genuine value investors is that we, as human beings, love – and are heavily influenced by – stories. Just like our early ancestors created myths to explain scary natural occurrences, today stockbrokers and asset managers create myths to explain scary random movements in stock prices.

Consider this: People are moved by emotion. The best way to emotionally connect other people to one’s agenda begins with “Once upon a time…” Psychological test results repeatedly show that our attitudes, fears, hopes, and values are strongly influenced by story. In fact, fiction seems to be more effective at changing beliefs than writing that is specifically designed to persuade through argument and evidence.

When we read dry, factual arguments, we read with our defenses up. We are critical and skeptical. But when we are absorbed in a story we drop our intellectual guard. We are moved emotionally and this seems to leave us defenseless.

I have been involved in financial markets for around 25 years; and I have seen stories destroy capital for investors many, many times. Every time, the movie is the same one, it just has a different name. Even better – the movie is always based on a true story; it just gets taken too far. But these stories consistently lead even smart people to suspend belief. Consider these examples:

  1. Portfolio Insurance in the late 1980s. Investors believed they could take on any amount of risk in the stock market, because they would be able to sell futures to hedge themselves if the market were to decline. When the market opened down 22% on Monday 19 October 1987, there was no insurance to be had at any price. Today, you may ask, what were they thinking?
  2. The Asian Tigers in the mid 1990s. Asia would grow and grow and grow. Its people were industrious and its economies were industrialising. They were also using leverage to grow so rapidly. That debt came home to roost in the late 90’s with the emerging market crisis. Because of very poor capital allocation, corruption and crony capitalism, over the long term Asian stock markets have underperfomed global stock markets by a wide margin. Again, you may ask, what were they thinking?
  3. Small Caps in the late 1990s: In South Africa in the late 1990’s it was widely believed that big companies were like dinosaurs – lumbering, on their last legs, and soon to be extinct. Small companies would take over the economy. The FM even ran a lead story called “The death of the blue chip” Small cap unit trusts proliferated. This of course all ended in the market crash of August 1998. Compare the view of 15 years ago with today’s view on companies like SAB, Richemont and Naspers. So, what were they thinking?
  4. The “New Era” at the turn of the century. Technology would change our lives, and as a result there would be massive earnings growth as far as the eye could see, according to John Chambers, the CEO of Cisco. He is still the CEO of Cisco, it has grown quite rapidly, but today the share price of Cisco is only a quarter of what it was in 2000. And Cisco was one of the more positive outcomes. Again, what were they thinking?
  5. Afro-pessimism in the early 2000s : South Africa was ex growth,and Africa was “the dark continent” (According to the Economist) Companies couldn’t move their HQ’s to London and New York fast enough. People queued to pay 6% for asset swaps to take more money offshore than they had – at R15 to the US$. 10 years later, SA has been one of the best performing stock markets in the world over the past decade, and the Rand is 30% stronger than ii was in December 2002.  So, what were they thinking?
  6. The US Housing bubble in the mid 2000s. They just don’t make more land, and houses always go up in price. Until they don’t, of course. Enough said about this stupidity. What were they thinking?
  7. The commodity super cycle, also in the mid 2000s. China will grow as far as the eye can see – there have 800 zillion potential consumers there, and they are all prepared to work for nothing. True, but all 800 zillion of them also want to take the Gwai Lo for a ride. And the ride ain’t free. Today, the Chinese market is trading at a third of its level of 2008, and commodity stocks have collapsed. Mercifully (for the kids at least), fewer people are teaching their kids Mandarin.What were they thinking?
  8. And finally, Quality dividend income – this is the story currently in operation. I’ll leave you to think about the wisdom of paying any price for a stock just because it has an ability to sustainably pay a growing dividend.  But I know how this story ends. Heres a clue: Repeat after me, what are they thinking?

The thing is, these stories all made us think we knew what was going on, when in reality, we knew very little about what was actually happening

So, what can we as genuine value investors do to avoid being caught up in the story?

It’s very hard to know when you’ve got an edge based on favourable odds. However, you can build a margin of safety into your assumptions sufficiently conservative to minimise losses. That’s why value investing works – you are betting with an edge that you have created by thinking independently, doing your homework, and finding opportunity in the fear and greed of other investors who have bought into the story.

So, to avoid a Black Swan event affecting your investments negatively, you need to practice what Nassim Taleb calls “via negativa” You need to know what you don’t know.

And there is a lot of that.

*Piet Viljoen started out as a lecturer at the University of Pretoria, and then joined the Reserve Bank as an economic analyst. He became a portfolio manager at Allan Gray Investment Counsel in 1991 and in 1995 moved to Investec Asset Management. Piet founded RE:CM in 2003 and is its Chairman.

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