Which among all the operators in the financial markets--from the Ivan Boeskys to state retirement systems controlling tens of billions of dollars--has the greatest advantage? Keep this question in mind as we ponder one of the investment world's more curious follies and some of the evil practices it has spawned.
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You probably noticed long ago that the approach to investing we advocate is quite different from those underlying much of what you will see in the financial press and usually promoted by brokers or other investment professionals. By this we don't mean to imply it is new or unique; on the contrary, our methods are quite old-fashioned and are practiced by a small band of crotchety types who typically lurk in the shadows of Wall St. They sometimes make the headlines when news of some of their activities leaks out, but usually their work isn't the kind of stuff that makes for exciting stories that can be sold to brokerage house customers. As clients you have had a taste of what the difference means in our oft-repeated skepticism, cautious buying and, especially this year, our ability to sit quietly and patiently like a watchful spider when there is nothing worthwhile to do.
If our attitude towards the investment process doesn't sound like something that would be advocated by the usual crowd on "Wall St. Week", it follows that we should take a different approach to evaluating the results of our operations as well. After all, someone who worries about quarterly, monthly or daily fluctuations in market values has a very different mindset than an investor who purchases businesses and has the stamina to hold them for longer periods of time - possibly decades. This is not to imply, of course, that the clients of such an investor can ignore what is being done with their money, only that they need to keep in mind that they are entrusting their funds to someone who thinks differently from and who should be held to different (in reality, higher) standards than the gunslinging crowd that makes the newspapers. We will discuss our views on how we feel investment results should be judged. But first, let's take our usual critical look at how it's all-too-often done by those who engage in the funny business of managing other people's money.
As you can tell from the opening paragraph (as well as previous letters), we take a rather dim view of Wall St. in general and nowhere is our view dimmer than when it comes to performance, the term used when conversation among investment people turns to the subject of how their stocks are doing. The very word implies some sort of contest or race against the clock. Among those in the brokerage and investment management communities for whom the stock market is more than just a place to trade business ownership interests (the vast majority), the fascination with performance is all-consuming. (One would think that if they spent as much time and energy on making good investments, performance would take care of itself--more on this later.). While the evaluation of investment results in an intelligent manner is appropriate, it is the application of the race mentality to investing which roils us and, in our opinion, distorts the meaning of the term. We'll illustrate the phenomenon by way of an extreme example: the events of the year 1987.
In the first nine months of 1987 the stock market as measured by the S&P 500 rose over 35%. This stupendous rise in prices had no basis in reason: the value of American industry did not increase by over one-third in that short period of time. Furthermore, it made no more sense to buy the average stock in January of that year than it did in August because valuations were simply absurd at both times. Now imagine yourselves in the world of the typical money manager in such an environment. If you sell stocks early in the year (at high prices) you run the risk of losing clients (i.e., your livelihood) to other managers who are willing to hold or continue buying stocks in a bet that the market will continue to rise. So, there is tremendous pressure to own stocks. Not only that, there is a need to buy more stocks since it is precisely during such times that your business attracts more money from those eager to get in on the action. How do you buy stocks in an already overextended market? Well, you look for companies selling at cheaper valuations than average or you try to find "groups that are lagging" which you hope will "catch up" with the rest of the market. [Note that the object here is not so much good investing as it is relative performance.] The risk in all of this, of course, is that you are exposed to market "corrections" (that is, prices fall instead of continuing to rise); but that's OK if all your competitors are hurt, too, or if your stocks don't go down as much as the market. Better still if the other guys do worse than you. But if the correction is too severe (as in October 1987), your clients still won't like it.
The first thing to note about this fascinating world is that it is relativistic. If the average stock sells for 20 times earnings (a high valuation historically) and you find a stock selling for 15 times, it's cheap. If one stock has risen less than average, someone somewhere will devise an argument to prove it's attractive. If you lose less money than the other guys, you're ahead of the game. Another remarkable thing, and to our thinking a critical weakness in the system, is the dominance of institutional imperatives over rational thinking and considerations relating solely to the investment merit of securities. In other words, the competitive dynamics of the money management business itself tend to override the investment process. What the market is doing, how you are doing this quarter versus the market, how your competitors are acting and what your clients think become as or more important than trying to determine if a business is attractively priced. Clients, too, are unfortunately now full participants in the game because in more recent years an army of consultants has sprung up that has succeeded in educating them in how it's played. Incidentally, consultants have also succeeded in turning the investment evaluation process, which should be a relatively simple affair, into an immensely complex, gold-plated business opportunity for themselves full of elaborate statistical analyses, cost studies, etc. - all for an appropriate fee: consultants have their own institutional imperatives!
Another development that stems directly from changes in the money management industry and less from any real distinctions in investment operations is the specialization into rather loosely defined investment "styles". "Value", "Growth" and "Momentum" are common designations which you may have heard of. The proponents of any given style typically claim that their methodology produces better long term results or good results at lower risk or that it "outperforms" at different points in the "market cycle". Mostly, however, these distinctions are little more than marketing concepts designed to help grow the investment manager's business. We find evidence for this belief in the fact that the trend towards specialization really accelerated in the 1980s as pension assets exploded, creating a huge market for investment management services and stimulating the proliferation of money management firms. In an industry where you are bidding for much-sought-after business, one way to make yourself stand out from the crowd is by using fancy packaging--like selling soap.
The effects of such distinctions are quite real, however. Specialized managers often forego considering outstanding investment opportunities simply because it's "not their kind of stock". A more serious problem arises when the specialized stock universe itself changes. For example, "value" managers did well in the early 1980s by owning large, stable and highly profitable companies that had valuable franchises. As these companies either were taken over or rose in price to such an extent as to drop from the value universe, other, less desirable companies took their place. Such companies often included cyclical industrial businesses or financial companies that were less likely to experience dramatic increases in valuation. As a result, many value managers saw poor "relative performance".
A similar transition is now taking place among the "growth" managers. This group did well by owning companies experiencing consistent increases in revenues and earnings, many of which were found in the consumer goods and drug industries. If you have read anything about Merck or Philip Morris during the last six months, you probably are aware that the stocks of these types of companies have been among the less impressive investments of the year. So, growth managers are turning elsewhere for growth and are finding it increasingly in the technology sector. Many technology companies are indeed growing rapidly, but they are entirely different animals subject to rapid change and unpredictable and vicious disappointment. The clients of growth investors could be in for some harrowing experiences, if not results that are less desirable than expected. It is a mistake to confuse the "growth" style with "growth of capital".
We believe that the most meaningful distinction, and one that is often lost sight of during periods of overexcitement, is the one between investment and speculation. Benjamin Graham and David Dodd, who founded the modern discipline of rational security analysis, defined the investment concept, and distinguished it from speculation, thusly: "An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative". This probably eliminates a good deal of what passes for investment in the modern financial world. In our view, certainly the commitment of funds in an operation the success of which is purely dependent upon someone else's projection of favorable developments in the future doesn't qualify; neither does simply buying a stock with a low P/E, or one which is just up or down in price. Proper assessment must be made of what the business the stock represents is worth within its industrial and historical context, allowing conservatively for possible future developments.
In our equity investments, our operations can be distinguished as follows:
1) We do not invest with the stock market. Whether the market averages rise or fall or what they did last quarter is of no interest to us.
2) We focus on investing in businesses that are selling at reasonable prices. This could conceivably include good businesses at average, as opposed to inflated, prices or mediocre businesses at cheap prices. We take advantage of the stock market mechanism: its occasional irrationality provides us with good opportunities.
3) If we know of no favorable business investments, we will refrain from activity, either holding our funds in cash instruments or fixed-income investments which, although of mediocre prospect, offer relative safety of principal.
4) We maintain independent, critical judgement, even in the face of persistent pressure: to do otherwise would be a disservice to our clients.
The objectives of our efforts are:
1) To make good investments.
2) Never to Lose; i.e., never to have a down year. This objective has to do with risk control. We are not saying, of course, that we won't lose or that we will be immune from disappointment with individual securities--no one can make such a claim. But by setting such an objective, we are motivated to use care in making our commitments.
If we are even modestly successful in reaching these objectives, we are convinced that we can achieve satisfactory results. Good investments should improve the chances of favorable outcomes. Never losing would unleash the power of compound interest. In other words, performance would take care of itself.
Given this mode of operation and set of objectives, how do we evaluate our results? We prefer to keep it simple: we are looking for equity-like returns over a long period of time, achieved at an understandable level of risk and for a reasonable cost. In the final analysis, however, it is our clients who will have to judge for themselves whether our efforts are worth their fees. Accordingly, once a year, after year-end, we will provide our investors with ample information to make this judgement. This policy will, we hope, encourage a long-term view and help clients take a calm, rational approach to their finances. We will steadfastly resist all efforts to discuss these matters on a more frequent basis--it just doesn't make sense. We lose very little sleep over the stock market and our involvements in it. We hope our clients will have pleasant dreams as well.
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Now, let's return to the question posed at the beginning--who has the greatest advantage? To us the answer is clear: the individual investor. And why? Simple: no institutional imperatives! The individual, or, to qualify it a little, the individual who knows what he or she is doing, is able to do anything--buy, sell, growth, value--with no concern for what others think or do. At anytime: individuals can move boldly or wait for better terms. More importantly, the individual can choose to do nothing if there is nothing to do--without penalty.
Dennis Butler, MBA, CFA
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