The Meaning of “Fish Where the Fish Are” in Investing

“Fish where the fish are” is a quote by famous investor Charlie Munger to explain the art of value investing.

All investors want to buy low, sell high.

They want to buy a stock, and sell it some day at a higher price.

Taken to the extreme, this core idea represents what value investing is all about. Value investors believe that the stock market (“Mr. Market”) is sometimes irrational. Value investors look to exploit this irrationality by buying stocks that are irrationally unfavored, creating a “margin of safety” to the investment.

Truly following a value investing approach means accepting some harsh realities.

One of the toughest is the lack of control you have on prices. This is where the “fish where the fish are” comment comes in, one that my good friend and business partner Dave Ahern reminds me of all the time.

Because the market is sometimes irrational, there are times to find irrationally priced (undervalued) stocks.

But because the market is only sometimes irrational, there are times where you won’t be able to find many irrationally priced (undervalued) stocks.

You have to accept that severely underpriced stocks with HUGE potential are only available sometimes.

Or, there will be times where the fish are staying in the same spot.

A sector or industry can stay undervalued for a significant amount of time. The rest of the market might stay rational for a significant amount of time.

To truly follow the value investing approach, you might be buying the same types of stocks in the same industry (or cyclicality) over and over again.

The risk is that your over religiousness to value can lead you to HUGE risks from a lack of diversification.

So you have to make trade-offs.

Finding the right amount of value investing for you means understanding the hidden implications of that journey.

Defining Value Investing

Fishing where the fish are, or value investing, has undoubtedly worked for lots of people.

It raises two key questions:

  • Why should I fish where the fish are?
  • What makes all the fish swim to a place in the first place?

Translating this analogy to value investing:

  • Why should I do value investing?
  • What creates the opportunities in value investing?

To answer these questions, we will reference the excellent book by Bruce Greenwald called Value Investing: From Graham to Buffett and Beyond.

Greenwald wrote a great chapter he called “Searching for Value: Fish Where the Fish Are.”

This chapter and others really lay out the value approach nicely.

To start, let’s go over the many reasons that value investing has been trumpeted as “the way” by many people.

Why Should I Do Value Investing?

There are lots of studies which have shown that value investing has beaten growth investing over long periods of time.

But I’d caution you to examine the details in all these arguments.

Sometimes the devil can be in the details.

For example, investors reference studies by James O’Shaughnessy and others which have taken the entire universe of stocks over a 40+ year time period and examined yearly performance.

By grouping a universe of stocks into a value “bucket” or growth “bucket,” O’Shaughnessy and others showed that the highest ranked value stocks beat the highest ranked growth stocks in a one-year period.

In these studies, the highest ranked value stocks are refreshed every year.

In other words, for a value investor to match the performance of one of these studies (value beating growth), the investor would have to buy a bucket of stocks and sell out of that same bucket in 12 months or less, every year.

For most average investors, that’s pretty impractical.

Not to mention the biases that can get in the way of a strategy like this.

A big reason why a system of buying a bucket of stocks beats the market might stem from that simple fact: it is systematic.

Investors, being the human beings we are, naturally like to have control. So we are more prone to tinker with portfolios, which could completely eliminate the outperformance that a systematic approach might have generated.

Not sticking to a systematic approach because it is buying obvious garbage companies, or questionably immoral or fraudulent companies, could leave out the very best performers over a short time period.

Value investing by the definition of ranking stocks by P/B and P/S has worked in the past, but is it right for you?

It could be (it is for me). Read on before making your decision.

Why Should I Do Value Investing? (Part 2)

Certain value funds and value fund managers have beaten the market in certain time periods.

That’s a fact, and can be very convincing.

Again though, I caution taking those results at face value without thinking about them much.

ALL investing performance depends on the time period examined.

Most examinations of fund manager performance are based on specific starting and ending points. But most investing strategies don’t really have an end point… we are all lifelong investors.

So a fund manager might look better or worse than they are, depending on what starting and ending point you are looking at.

Value stocks and growth stocks constantly rotate between outperformance and underperformance between each other. So evaluating a growth manager after 15 years of growth stock outperformance, or evaluating a value manager after value has reigned supreme for 15 years, is not really a fair comparison.

It is misleading at best.

The real evidence of a highly skilled investor is those who have sustained track records through many decades, through both value and growth cycles.

That’s much rarer, and is reserved for the special few.

Why Should I Do Value Investing? (Part 3)

The last point about value investors we will make here has been the performance of the “Superinvestors of Graham and Doddsville.”

Arguably the greatest anomaly in stock market investing has been Warren Buffett.

Buffett was taught by his professor Benjamin Graham and David Dodd at the Columbia School of Business. Other investors also learned from Graham and Dodd around the same time. A shocking number of them went on to also beat the market over a long period of time.

The common refrain against active managers is that statistically, a small minority are expected to beat the market.

You get the small minority whether performing a long string of random coin flips, or something that can also look random like the performance of many stock pickers.

Buffett argued in his speech about the Superinvestors that when almost the entire minority is clustered and with the religion of Graham and Dodd, it has a good chance to be something more than randomness.

While undoubtedly inspiring, it begs the question: if outperformance to this degree is so rare, are we really the ones to duplicate that performance?

Statistically, the answer is no.

But that doesn’t mean you shouldn’t try to save and invest more, and do better for your life.

What Creates the Opportunities in Value Investing?

There are real, tangible and logical reasons that stocks fall out of favor in the market.

And they can be more clear than the simple explanation that it’s due to randomness.

Greenwald lays out many of these in the fish where the fish are chapter, and you might realize a common characteristic. They all have to do with the institutional imperative.

Now, the institutional imperative is not some active conspiracy.

Rather, we must acknowledge that institutions are made up of human beings, and human beings all have our own motivations and biases of our own.

Let’s digest a few of these.

Institutional Imperative: The Small Cap Effect

The fact of the matter is that everyone on Wall Street is playing a different game.

Yes we are all trying to make money, but the ways in which this money is made can all be different. It is packaged and modularized in a million ways to one.

Fund managers and ETFs have their own prerogatives.

Many of these are segmented to a particular style. You might have Large Cap Growth and Small Cap Value.

The point is that not every fund is trying to beat the market.

Style funds are there as entrees, for investors to mix and match to construct their own full portfolio.

With this institutional imperative of needing to stay in your mandate, the stocks that are most commonly ignored in a mandate can be undervalued.

For example, a Large Cap Growth fund is probably not allowed to buy Small Cap stocks. If the biggest funds on the Street are all Large Cap funds, then all stocks that are not Large Cap can all become undervalued.

And then you have the sheer size of funds.

Even a fund without a size mandate might have a particular diversification strategy in mind. If a $50 billion fund tries to split its portfolio into 50 positions equally, then it has $1 billion per position to allocate. A fund like this probably doesn’t want to buy out an entire company and manage it.

So this fund wouldn’t be able to buy any stocks with a market cap of $1 billion or less.

The numbers are actually lower than this when you consider ownership limitations. Whether for regulatory reasons or otherwise, many funds don’t want to cross above having a 10% ownership stake of a company.

So for this fund, any stocks with a market cap of below $10 billion would be out of the picture, because the $1 billion to allocate would cross above the 10% ownership stake for any company smaller than this.

The Small Cap Effect, or tendency for small cap stocks to outperform large cap stocks, can sometimes be attributed to the difference in fund mandates leading to undervaluation with certain stocks at certain times.

Institutional Imperative: Safety in the Crowd

Many fund managers have a tough act to follow.

There is huge incentive to follow the crowd and buy the same stocks as everyone else.

This is because there is little risk in following the crowd. But there is lots of risk in sticking your neck out against the crowd when you end up being wrong.

Greenwald alikens this phenomenon to the old “you can’t go wrong buying IBM computers” adage from the old days in IT.

Sticking your neck out, going against the crowd, often doesn’t get much praise.

But it does draw lots of criticism when you are wrong. You look “stupid” because you dared to be different but made a mistake.

This safety in the crowd tendency can create undervalued opportunities.

If the crowd decides a stock is not good, then many in the crowd will go along with this thinking even if the company actually has solid fundamentals and a great future.

The crowd sometimes makes certain decisions on the future; these are often wrong because the future is so unpredictable.

By simply avoiding the crowd, you can do great things for your performance over the long run.

But this is much easier said than done.

We all want to feel vindicated and smart, and the easiest way to do this when investing is to follow the crowd. Hearing lots of people confirm our decisions convinces us we are all correct.

Institutional Imperative: “Window-dressing”

The last imperative we will discuss today is “window-dressing” at the end of the year.

It’s hard to know with certainty how much this has gone on or will continue to, but the general idea is this…

Portfolio managers want their clients to stay with them for the long term.

Clients tend to look at a portfolio, and they want to see that those names have had great performance.

So, some managers will intentionally sell out of the losers while keeping the winners, to make the individual positions in the portfolio look better than they actually are.

Greenblatt argues that this can create great opportunities at the end of the year.

It may be worth considering, as it should lead to irrationally undervalued companies.

The Bottom Line

I hope this post has inspired you to learn more about value investing and whether it’s the right approach for you.

I will admit that actively managing a stock portfolio is hard.

Research has shown that, at times, 70% or more of active managers have underperformed the market.

For every one Warren Buffett that’s handily outperforming the market, there might be 5 or 10 managers on the other side of those trades who are underperforming.

It’s the nature and mathematics of the stock market, and one we must humbly respect and stay cognizant of.

I believe that the right approach to value investing for the average investor is somewhere in the middle.

At least it is for me.

It means accepting that sometimes it’s better to fish where the fish are. But also, sometimes it’s better to maintain diversification and respect that we are probably wrong at least 49% of the time.

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