By John Looby
The lemming is a small rodent usually found in the Arctic Circle. Though generally unremarkable, a peculiar pattern of lemming behaviour has entered into popular consciousness.
For reasons which have yet to be fully explained, when a lemming at the front of the herd plunges to his death off an Arctic cliff-side his fellow lemmings dutifully follow him to their doom.
As a powerful explanatory image for comparable human behaviour in a wide range of domains, this peculiar pattern of lemming behaviour is unfortunately ideal.
Aswath Damodaran is a Professor of Finance at the Stern School of business at New York University and has been teaching a seminal class in asset valuation there since 1986. In addition to teaching, he has published a number of widely regarded books on the subject. The most well known is probably his contribution to the popular ‘little book’ series: ‘The Little Book of Valuation’, first published in 2011.
Damodaran uses the peculiar pattern of lemming behaviour at the cliff-side to usefully categorise approaches to investing. More particularly, he uses it to rationalise his decision to only make investment decisions based on asset valuation.
To Damodaran, all investors can be categorised as belonging to one of three categories of lemming:
- Proud Lemmings: Momentum investors who proudly proclaim their unquestioning devotion to following the lead of others. Their approach is simply to buy what everybody else is buying and sell what everybody else is selling, convinced that what has worked in the past will continue working. For Damodaran, while this may prove to be the case for a period, such an unquestioning approach inevitably leads such lemmings to follow their leader over the cliff-side to their investment doom.
- Yogi Bear Lemmings: Momentum investors of what Damodaran calls the Yogi Bear School. Yogi Bear is a cartoon character from the 1970’s whose famous catch-phrase was ‘smarter than the average bear’. Investors of this school believe that they can follow the herd right up to the cliff-side, benefitting from the profit of being on the right side of momentum, while being clever enough to pull back just in time to avoid the fall – lemmings who are ‘smarter than the average lemming’.
Doubting the ability of any investor to be consistently smart enough to spot the precipice, Damodaran is as scathing of this approach as he is about that of the Proud Lemmings
- Lemmings with life jackets: Investors who follow a credible process for assessing any asset before they buy it. While this gives no guarantee that the investor won’t still plunge lemming-like over the cliff-side, the following of a credible process of assessment lessens this likelihood.
Possibly more importantly, in the event of getting wet, it acts like a life jacket to give this lemming a greater chance of survival.
To survive and succeed as an investor, Damodaran advises being a lemming with a life jacket.
Our life jacket is the building of broadly diversified portfolios deliberately tilted towards stocks where sustainable and growing dividends are deemed an attractive likelihood, and which are also deliberately tilted towards relative cheapness and relatively high quality.
Without it, we believe that our chances of plunging and drowning are dangerously greater.
This message is particularly apt for investors in emerging market stocks over the past twelve months.
In an environment where the fear of faltering activity continued to grow, investor demand for stocks that seem to promise this scarce exposure accelerated. Growth outperformed Value by the biggest margin since 1999, and this relative performance gain is now a striking 27% since 2012. The din of quickening herd hooves has been getting louder.
A handful of such richly valued growth stocks have proven to be a particularly powerful magnet. So powerful indeed, that the top 10 performing stocks in emerging markets last year accounted for over 280% of the index performance, while just the top two accounted for over 130% – hooves pounding louder still:
Interestingly, a very similar pattern was evident in North America in the twelve month period between June 2014 and June 2015. Growth outperformed Value by 10.6% and just five stocks accounted for 104% of the index return. Since then this trend has stalled. There has been a clear broadening of the market and value has performed broadly in line with growth. The lemmings with life jackets have been reaping the benefit.
Successful investing is possible but not easy. In the saltier words of Charlie Munger, the long-time business partner of Warren Buffett at Berkshire Hathaway:
‘It’s not supposed to be easy. Anyone who thinks it’s easy is stupid.’
In the perennial challenge of trying not to be stupid as an investor, the image of the lemming and the cliff-side is particularly helpful.
Warning of the dangers of being a proud lemming or a lemming of the Yogi Bear School, and recommending instead that we invest like a lemming with a life jacket; Aswath Damodaran has significantly enhanced our likelihood of success. For him, the seven most dangerous words in investing are:
‘They must know something that I don’t!’
Words that emerging market investors, exposed to the extreme concentration of performance in a small number of richly valued growth names, could well heed to their benefit in the period ahead. It has certainly proven prescient for their North American counterparts.
John Looby is a global equities portfolio manager at Kleinwort Benson Investors
