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Hope Is Not a Strategy

Saturday - 2/9/2013, 5:21am  ET

The following commentary was originally posted on FoolFunds.com, the website of Motley Fool Asset Management, LLC, on Jan. 9, 2013. With permission, we're reproducing it here in an edited form.

It's easier to fool people than to convince them they have been fooled.
-- Mark Twain

Happy New Year!

The markets closed out a turbulent 2012 with one last worry: whether Congress and President Obama would come together with an agreement that would prevent the federal budget (and thence the economy) from plunging over the figurative fiscal cliff. During the month of December, more people asked me about whether we were going over the cliff than anything else. OK, except for "What am I getting for Christmas?" But that was more a case of a small set of people asking the same question many, many (many) times.

(Also heard many times: "Why the hell are you going to Nigeria?," the answer to which lies in our just-published recap of our research trip to this fascinating "Sleeping Giant of Africa." See "Nigeria: The Giant Awakens.")

What we witnessed in December was a strange confluence of market factors. First, as is normal, many investors engaged in tax-loss selling so that they could net out losses to lower their tax exposure. With the looming rise in capital gains tax rates, though, December 2012 also saw witness to significant tax-gain selling, whereby investors went ahead and sold stocks that had increased in value, locking in the 2012 tax rate. In addition, fear and hope regarding the fiscal cliff as well as the Federal Reserve's pledge to maintain its zero interest rate policy for the foreseeable future had, in our opinion, the unfortunate effect of continuing to distort stock market returns.

These types of distortions have real implications for investors. For example, I recently ran a screen measuring the stock market performance of all of the companies in the Russell 2000, the most commonly quoted measure for U.S.-domiciled small-capitalization companies. The stocks of companies in the bottom 25% in terms of returns on capital – one of our favorite measures of quality – dramatically outperformed the quartile with the highest returns on capital during the 12 months through October 2012.

In case you have any question about why we do not get particularly excited by short-term stock movements, please consider the implications of the preceding paragraph. After all, this single data point suggests that a great strategy for superior investing returns over the last year would have been to go out and load up on companies with horrible operating profiles. While we are certainly not above doing the occasional dumpster dive for a low-quality company that we believe trades at a meaningful discount to its fair value, we believe that Warren Buffett's advice that "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price" is something close to gospel. We believe the companies in our portfolios tend to have superior operating metrics, even if they are small (which market orthodoxy considers to be riskier), based in developing markets (ditto), and have somewhat lumpy earnings (double ditto). If the market – as it is wont to do from time to time – focuses on things other than company quality, well, we can wait. We do not believe that buying into a fad or trend -- even one built upon macroeconomic themes -- and hoping it continues, is a great basis for long-term investing success.

Not the outcome you had hoped for
Not too distant from my house in Vienna, Va., is a remarkable building at the corner of two main thoroughfares, Chain Bridge and Old Courthouse roads. The building's notable feature is a large, vertical arch framing a concave edifice. It's possible this building has an official name. Probably something insipid like "the CrossePointe TradeWindes Building," or the "EastGATE Towers West." It doesn't matter, because everyone calls this building the same thing: the "Toilet Bowl Building." It even has its own Facebook page.

(I just looked it up: it's called the "Tycon Courthouse Building." Bleh.)

This is a pretty choice piece of land, hard by Tysons Corner, the largest suburban agglomeration of office space in the United States. I'm sure back in 1983, neither the architect nor the builders nor the developers tried to build a building that looked like a giant potty. And yet, that's exactly what they managed to do.

Ultimately, the architectural theme they intended to invoke is irrelevant to the outcome they achieved. I giggle a little to imagine the first time that the developer stood before the building – probably late in its construction – and thought "is it just me, or does that kinda look like a commode?" By then, it was too late: The crime against architecture had already been committed, much to the delight of decades' worth of direction-seekers.

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