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Wednesday 6 April 2011

Of Mice and Templeton Moments

An Age of Genius

Sir John Templeton was one of the last century’s greatest investors who, like most people who exhibit unusual skill in the financial markets, had an appropriate view of the balance between investing fundamentals and investor psychology. He died only a few years ago, at the great age of 95, and almost to the end he was still making strikingly accurate predictions, some of which are yet in the process of coming nastily true.

At one level Templeton's approach to investing was simple and familiar: go against the flow and seek out opportunity where no one else dares to look. As usual, the problem with such advice is that it’s very easy to give and very hard to take. But we need the evidence of the mice to tell us why.

Dotcom Difficulties

By the time the dotcom boom struck us at the end of the last century Templeton was already in his late eighties, a time when most of us will be spending our time in exciting hobbies such as competition drooling and bedpan tennis. Sir John, however, was busily figuring out how to make his next fortune.

Burton Malkiel’s tour-de-force of a book, A Random Walk Down Wall Street, makes the case that price movements in markets are mainly random in nature. However, he also makes an additional point that is often missed: that even at the height of the dotcom boom when it was obvious, to almost anyone capable of working a can opener, that stocks of negligible net worth were selling at extraordinary multiples of earnings – infinite in many cases – figuring out how to bet successfully against this tide of money was extraordinarily difficult:
“While it is now clear in retrospect that such professionals were egregiously wrong, there was certainly no obvious arbitrage opportunity available".
No Arbitrage, Eh?

Although this prediction was prescient as far as most of us were concerned, or at least it would have been if it hadn't been given in hindsight, it didn't prove to be very accurate as far as Templeton was concerned. He figured that the entire dotcom experience was based on momentum. He also figured that the company owners would know this but would be unable to sell for a six month lock-in period after IPO. Ergo, they would sell out as soon as this period finished and effectively reverse the momentum.

He identified and shorted 85 different stocks in the run up to their founder's lockouts ending and walked away with a million bucks for every year of his life. No arbitrage opportunity, eh?


Templeton's ability to identify predictable trends and correctly discern the likely trajectory of events is the hallmark of his career. Subsequent to his dotcom success he turned decidedly bearish on the US consumer, as this Forbes article from 2004 reminds us:
“His big concern today: the US consumer. He says Americans have taken on too much credit card and mortgage debt … Templeton predicted house prices will fall and defaults rise”.
And of course, he suggested owning Treasuries rather than stocks. Prescient, even if he was several years too early with that call. The following year he made an even more acute observation:
“Over ten-fold more persons, hopelessly indebted, leads to multiplying bankruptcies: not only for them, but also for many businesses that extend credit without collateral. When this occurs, voters are likely to insist on rescue-type subsidies, which transfer the debts of governments, such as Fannie Mae and Freddie Mac.”
Which points up a lesson we've seen multiple times before. in the likes of Warren Buffett Bias, Soros' Economic Reflexivity, A Keynsian Theory of Mind and Anatomy of a Growth Investor. Unsurprisingly, if you want a decent prediction about what markets are likely to do in future you're better off looking for pearls from the lips of great investors than from the myriads of people who make their living writing about the future. Present company not excepted.

The Ten Maxims

Templeton’s philosophy was built up over a near sixty year career and was eventually captured in the so-called “ten maxims”. Consider:
“When any method for selecting stocks becomes popular, you need to switch to unpopular methods”.
This, of course, can apply to any method we can imagine. Value investing, when it becomes popular, can lead to much lower longer-term returns than its fans imagine. The idea that there is no one method of stock selection that works all the time is a difficult one to get our heads around but makes perfect sense if we accept the idea that people’ current stockmarket behaviour gets modified by their previous behaviour in a constant feedback loop.

Contrarian in Style and Substance

This isn’t to say that value isn’t what Templeton focused on, just that his methods for determining it varied over time. Like so many of the best investors he felt his returns came from standing above the ebb and flow of excitable market psychology and acting in a contrarian fashion:
“If you buy the same securities as other people, you will have the same results as other people. It is impossible to produce superior performance unless you do something different from the majority. Buying when others are despondently selling and selling when others are greedily buying requires the greatest fortitude and pays the greatest reward.”
Which is easy to say and darn hard to do, because it’s exactly what our brains are hardwired to avoid. Most people know that mental anguish, such as caused by stockmarket losses, can lead to physical pain but it took a study on mice as recently as 2006 to show that there really is a feedback path from the psychological to the physical. Mental anguish can cause physical pain.

Our natural response to sources of pain is to run away from the problem which, in investing terms, is often exactly the wrong thing to do. Mastering this to learn that the pain is mental and can be defeated is a huge challenge and one that many people simply cannot overcome. These people should devote themselves to some activity less likely to cause them damage: something like drag racing while blindfolded and under the influence of drugs should do the trick.

The Templeton Moment

Of course, perhaps the most permanent reminder of Templeton’s philosophy is the so-called “Templeton moment”: the point of maximum pessimism:
“Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the right time to sell”.
Which is easy to say and obvious in many respects. Unfortunately it's terribly hard to actually put this into practice, as we'll probably find out shortly. As ever, it is never different this time, unless John Templeton’s near eighty year investing lifetime was simply an outlier in market experience.

Related articles: Warren Buffett Bias, Soros' Economic Reflexivity, A Keynsian Theory of Mind, Anatomy of a Growth Investor

1 comment:

  1. A little known fact about Templeton is he learned the value of being one of the only traders left in the room from watching his father (or uncle, I forget) at cattle auctions in the mid West.

    A lot of people who believe markets are entirely rationale 24/7 would benefit from a day in an auction house.