Stanford University Professor Deborah Gordon spends her days analyzing the behavior of harvester ants that populate the dry desert of Arizona. She's observed how an ant colony manages its water consumption in search of seeds, the ants' primary food source. Water is in limited supply for a desert ant, so it's important they balance their conflicting goals of foraging for seeds and consuming water in the process. Looking for seeds and conserving water is accomplished by having only a limited number of partially blind ants patrolling above the surface in search of food at any one time. If one of the patrol ants stumbles upon some seeds, it heads back to the nest and tells all of its friends. By touching the antennae of other ants huddling near the surface of the underground nest, the patrol ant gives the signal for others to join in the collective effort to search for seeds. This efficient food-gathering process results in far less water consumption for the ant colony as a whole. Instead of a large number of ants randomly moving about the surface, wasting precious water resources under the hot desert sun, they become active only when a high probability of gathering a large number of seeds exists.
Enterprising stock investors can learn a thing or two from these desert ants. A certain category of stocks identified by famed value investor Benjamin Graham is equivalent to a seed for which ants foragein the desert. Stocks that meet this filtering criterion trade at a price point below net current asset value (NCAV). As indicated in the chart below, the average return on a portfolio of NCAV stocks outperformed a small-cap index by nearly 5 percent on an annual basis. Many stocks trading below NCAV are smaller in size, so measuring their performance against the Wilshire US Small-Cap Index is appropriate.
* No more than a 5 percent weighting in any one stock trading below net current asset value (NCAV). In years where few stocks were available for purchase, the balance was invested in U.S. Treasury bills.
The average-return results from the chart above assume the NCAV portfolio invested no more than 5 percent in any one stock. If fewer than 20 candidates were available for purchase in a particular year, the balance of capital remained idle in low interest-bearing Treasury bills. Any changes made to the NCAV portfolio took place only once a year. An ant colony queen would be pleased to see the limited amount of energy expelled to achieve these stellar performance results. How often did funds sit idle in Treasury bills by restricting the portfolio to only stocks trading below NCAV? The chart below indicates the percentage of time over the long study period that investors were forced to remain inactive due to the sparse number of stocks available for purchase. Over the 63-year study period, a large amount of time investment capital remained on the sidelines. Value investors have some time on their hands if they don't relax their filtering criterion of only purchasing stocks trading below NCAV.
According to Dr. Gordon in her TED presentation, a large amount of downtime also holds true for harvester ants. I'll take the word of someone who makes her living digging up ants when she states that about half of an ant colony remains idle in the underground nest doing nothing most of the time. Sloth doesn't result in these tiny critters' buying the farm (even if it happens to be an ant farm). Whether it be ants or deep value investors, a large trade-off between inactivity and performance doesn't appear to exist. As with ants, lazy value investors can still produce stellar results by remaining underground and not wasting lots of energy foraging the universe of stocks when none are available trading below NCAV.
If this investment approach is such a great idea, why aren't more large financial institutions restricting their stock purchases to only ones trading below NCAV? As I've mentioned in a previous blog, the current financial engineering leviathan on Wall Street cannot implement this approach in real time because of its gargantuan size. The NCAV investment approach is not a scalable business model for oversized mutual funds that are eager to gather ever more assets from a retail public obsessed with stocks. The academic evidence has shown that mutual funds begin to underperform once their assets under management grow beyond a certain size. This is especially true for mutual funds that focus on small-cap stocks, with most NCAV stocks falling into that category. As mutual funds become bloated in size, they're also forced to bring on additional layers of workers to help out in managing the ever-greater piles of money under their control. This, in turn, leads to organizational diseconomies, compromising mutual fund performance even further. Desert ants have figured out a way to deal with these issues of colony size without the burden of having to add more central control systems. After a number of years, when the expanding ant colony reaches a certain size, a new queen is created and flies away from the existing nest to start a fresh incubator colony. As Dr. Gordon indicated, "Ants never make more ants; colonies make more colonies." For both ants and value investors, remaining below a certain threshold size increases the chances of survival in either a desert or on Wall Street.
Perhaps the next generation of investors will learn from the ants. Flying away from an oversized mutual fund to form a separate nest of NCAV stocks that is smaller in size seems like a prudent decision for an enterprising investor. Ants have it easier than value investors when it comes to finding the patience to remain on the sidelines and wait for the right opportunity. When few NCAV stocks are available to purchase, it's a tragedy that disgruntled value investors can't wait out these difficult time periods in an environment surrounded by ants. Excluding the queen, an ant colony consists of mainly sterile females that live in total darkness under the desert floor with nothing to do most of the time. Having the discipline to stop buying stocks at any price might be more easily implemented when distracted by this type of setting.