The Secret of Making Money in Stocks

If you’d had a crystal ball in 1960, you would have accurately predicted:

• the assassination of John F. Kennedy
• the expansion of both the welfare state and the Vietnam War (“guns and butter”)
• Richard Nixon’s wage and price controls and his subsequent resignation
• the end of the Cold War and the Soviet Union
• a one-day drop in the Dow Jones Industrials Average of 508 points
• gold prices fluctuating from $35 to $850
• Treasury bill yields fluctuating between 2.8 percent and 17.4 percent
• the Arab Oil Embargo
• lines at gas stations
• tanks in Tiananmen Square
• the failure of Enron, WorldCom, and others
• Ivan Boesky, Michael Milken, and junk bond trading scandals
• … and much more

Had you seen these cataclysmic events coming, you might well have concluded that stocks would be a terrible investment for the next couple of decades – that, in effect, the world as you knew it was coming to an end.

But, in the words of Warren Buffett, “none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital … Fear is a foe of the faddist, but the friend of the fundamentalist.” [Ed. Note: Ben Graham was an influential economist and investor, often called the “Father of Value Investing.”]

In 15 years of doing financial research, writing, and investing, here’s what I’ve learned about predictions that has helped me make money and avoid losses: Interest rates will fall. Interest rates will rise. Stocks will fall. Stocks will rise. This or that candidate will be elected president. But nobody knows for sure. There are only two things about the future that you can count on:

1. Trees don’t grow to the sky.
2. The world has a habit of not coming to an end.

So, despite the occurrence of all the events listed above, and much more, knowledgeable value-oriented investors went on to earn outsized rates of return.

In other words, it was far more important not to get scared out of stocks and to know something about investing than it was to have been able to predict some of the worst events and trends of the last 40 years.

The story of the Sequoia Fund provides an example for investors to follow. Sequoia is the fund Warren Buffett recommended to his former clients in 1970, the year after he closed his investment partnership. Richard Cunniff, a former Ben Graham student, still runs Sequoia. (Bill Ruane, Cunniff’s partner and a fellow Graham student, passed away earlier this year.)

The Sequoia Fund under-performed the S&P 500 in its first four years. It has under-performed the S&P 500 in 14 of the last 34 years. That’s 41 percent of the time.

But in the last 34 years, Sequoia has averaged 15.86 percent annual returns. A $10,000 investment in 1970 is worth about $1.9 million today, versus $535,000 for the S&P 500. If you’d pulled your money out after those first four years and put it in an index fund, you’d have made a huge mistake.

Think about that. Four years wasn’t enough time to give a true picture of the soundness of Sequoia’s basic value-oriented approach to investing.

Nearly half the time, getting rich felt like losing ground when compared to the rest of the market. In some years, getting rich by giving your money to Sequoia felt exactly like losing money.

Several other value managers have had equally impressive long-term results during the past few decades. Just go check out the results of Tweedy Browne Company, Longleaf Partners, The Clipper Fund, Third Avenue Funds, and The Oakmark Funds, to name a few.

Warren Buffett is certainly the most famous and successful of the value-oriented investment managers. He’s earned himself and his shareholders an average of 21.5 percent a year since 1965, or roughly 2,900 times their money!

That’s not a typo. Every $1,000 invested with Buffett in 1965 has become about $2.9 million today. That’s the power of compounding. But the power of compounding only works if you follow the advice of another famous investor, Peter Lynch: “The key to making money in stocks is not to get scared out of them.”

This doesn’t mean I’m perpetually bullish on the stock market. Quite the contrary. It means you’re better off ignoring the movements of the overall market. Instead, you need to learn how to figure out how much a given company is worth. The famous value managers I named above like to buy stocks between 30 percent and 50 percent below their fair value. And they only buy the highest quality businesses. That’s how they get those wonderful long-term results.

Over the next 5, 10, or 20 years, there’s certain to be a number of unpredictable economic and political shocks around the world. Perhaps there’ll be another terrorist attack, a protracted war in the Middle East, or a stock market crash. Who knows?

The answer, of course, is that no one knows. No one has a crystal ball. And even if they did, it wouldn’t matter. Because during the next several years, no matter what else happens, you can bet there’ll be safe, cheap stocks to buy. They’ll treat their shareholders well, compounding at rates far above what bondholders will earn.

As long as you understand that trees don’t grow to the sky, and that the world has a way of not coming to an end, you’re in the “sweet spot,” a place where you won’t be distracted by interest rate and stock market prognosticators and their worthless predictions.

“We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.”– Warren Buffett

[Ed. Note: Dan Ferris is editor in chief of the Stansberry Value Alliance, a group of financial research professionals focused on finding undervalued public equity investment opportunities. The Alliance publishes Extreme Value, a monthly research letter.]