Although investors are inundated with data about the financial markets -- price changes, advance/decline lines, investor sentiment measures, etc. -- and constantly fed opinions regarding their outlook and direction, there is really little of any significance that can be said about short-term movements in security prices. With that in mind, we will merely note that stock prices generally rose in the year's second quarter, although at a somewhat slower pace than during the first three-month period.
More importantly, average valuations remained unattractive. Our friends at Schroder Wertheim said it well in a recent report: “Stock prices are reasonable only in the context of the benign consensus view on inflation (low) and interest rates (stable to down).” Since we prefer to take a long-term view and feel that basing valuation on a current consensus of opinion is something akin to changing presidents with each new public opinion poll, our take on prevailing prices is a bit stronger: they make no sense and sooner or later people will get hurt paying them. The Schroder analysts go on to discuss the current mutual fund craze, stating that it “reflects both euphoria and some compelling long-term forces, chiefly an aging population with the real need to save and no acceptable alternatives. The long-term forces will remain, but the euphoria will not.” We hope the authors meant to imply that fund investors feel they have no acceptable alternatives. To our way of thinking, the 5% risk-free returns available in short-term treasury securities are quite acceptable, so much so, in fact, that the number bears repeating: 5% risk-free. Those who pooh-pooh mere single-digit results such as this should take the time to study the impact which compounding has on asset growth over extended periods of time. They might also note that 5% is a relatively good return when viewed in an historical context and that any positive result is better that the negative one they risk by committing money to an overvalued stock market.
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We have often commented, usually with derision, on the mutual fund phenomenon and recent musings on our part lead us once again to impart a few thoughts on the subject.
In the early 1940s there appeared a book with the mischievous title, Where Are The Customers' Yachts?, which poked fun at Wall Street, its delusions and, most particularly, its ability to make money regardless of how investors fared. At one point author Fred Schwed tells of the “benevolent soul who said at the beginning of the poker game, 'now, boys, if we all play carefully we can all win a little.'” This amusing little story was told in the context of a discussion about how the creation of the U.S. Securities and Exchange Commission, along with the passage of numerous laws protecting security buyers, had lulled the public into believing that speculation and investment would be “safer.” That was not, of course, the purpose or intent of the new legal safeguards. Nowadays it would appear that the role of making the public feel safe while engaged in risky behavior is being played by mutual funds, for it seems as if investors think that acquiring funds insulates them from the perils of stock ownership.
In the old days (maybe five to ten years ago) it used to be that mutual funds were a good way for savers, especially those of limited means, to get exposure to the higher returns offered by the financial markets without having to select individual securities. They offered diversification, professional management and, with patience, reasonably good results over the long term for well-run, general purpose funds. Now, however, the fund business has become huge, hyped and subject to forces which, in our view, work to negate these advantages.
Simple economics explains a lot of what has been happening in the industry: rising demand produces the potential for attractive incomes that in turn stimulates more supply. The media have closely chronicled the growth in demand for funds over the last several years: statistics on the monthly inflows of new money into fund companies attest to the popularity of these investment vehicles. Other data reveal the astonishing magnitude of the shift of money into this asset category -- our favorite being the fact that over 80% of the money ever invested in mutual funds was invested during the last five years.
In accordance with the laws of supply and demand, the industry has responded with gusto to the surge in interest by offering more funds and more funds of different types than ever, so that there are now far more of them than individual securities listed on the New York Stock Exchange. The securities markets have been sliced into every imaginable subset in order to offer buyers the ability to invest in and trade among various market sectors with ease. And, as often happens in ebullient markets of any kind, fringe elements have appeared -- operations engaging in riskier activities and employing questionable sales practices to tap the robust and often indiscriminate demand for the product.
What is the end result of the explosive growth in the fund business? First of all, there are so many funds now that merely selecting among them has become a business into itself, nearly as difficult as selecting individual securities as far as the novice investor is concerned. Secondly, investors have learned to engage in activities, similar to plain, old-fashioned stock speculation, which may be detrimental to their long-term interests. Whether intentionally or not, they have been encouraged to swap among funds or market sectors and chase after the latest “hot” fund managers. Such behaviors are the exact opposite of those needed for the patient, long-term approach required for successful investing, especially in equities. Finally, the environment within the industry itself has spawned erratic behavior among fund managers who, constantly looking over their shoulders at what their colleagues are doing, have become engaged in a competition with other money managers for customer assets as opposed to working to build client loyalty. The result is a short-term orientation all too typical of the investment business and one of the very things that funds are supposed to protect the investor against. Another fact often overlooked by fund buyers: most fund managers, again largely for competitive reasons, consider it their job to be “fully invested” at all times, but especially during bull markets, lest performance suffer relative to their peers. Investors, therefore, need to be wary lest they end up paying, indirectly through their fund shares, unreasonably high prices for securities.
Under these circumstances it is difficult for us to see why investors should feel safe just because their money is in a fund of some kind. Given what has been happening in the field, it is no longer so easy to recommend that people simply put their money in mutual funds. If there is one maxim that should be heeded when it comes to investing or almost anything else, it is that it is not a good idea to do what everyone else seems to be doing. While there are certainly well-run funds that eschew the passions of the crowd, it takes some work to find them and, once found, it is up to the investor to have the patience to let the investment process work and avoid the temptation to jump around from fund to fund, chasing the hottest performers or latest fads.
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A moment ago we alluded to a competition among fund managers to collect customers' money as opposed to their taking measures necessary to build long-term client loyalty. We find this divergence distressing because the two activities represent very different business motivations that do not necessarily lead to the same desired end, namely, the protection and growth of investors' assets. There is a big difference between collecting assets and doing well by your clients. The first is inherently short-term oriented since money tends to flow to those with the best recent records, to the detriment of longer term thinking that may produce as good or better results with less risk. The temptation for managers to seek out the hottest stocks to boost performance also enhances risk. Building client loyalty is a different matter. It is more difficult: expectations for immediate gratification may have to be dampened and clients may need to be educated as to what they can realistically expect from their investments, commensurate with safety of principal. This emphasis on the safety of the investor's capital is a consideration given greater significance than short term results. There is a realization that the best -- and safest -- results occur over a long period of time. Investing, from this point of view, is similar to starting a vineyard: plant the vines and three or four years later you can start to harvest grapes and make wine. Unfortunately, not all investors are temperamentally suited to this approach which, paradoxically, offers greater “safety” than the frenetic search for short-term gains.
We feel most comfortable with the latter, rather old-fashioned way of conducting the business and, in reality, our way of investing requires it: we avoid the popular fads and tend to get involved in areas that are less appreciated and which take time to come to fruition. Over the long term, clients tend to be better served by such an approach, and with less risk.
Dennis Butler, MBA, CFA
Commentary