One
thing that didn’t change much after the 2000 to 2002 decline is the
misperception that, when selecting investment managers, the most important
thing to look for is how they did last quarter or last year. It’s an obsession
that never seems to change much. But then again, in today’s culture, why should
it change? The advantages of capitalism have, unfortunately, led us to
consumerism and the belief that we can get anything, at any price, at any time.
With the advent of the internet, easy credit, and the sense of entitlement our
prosperity as a nation has fostered, many have come to believe that they can
have it all and they can have it all, right now.
It
is not my intention to debate whether this has served us well as a nation. What
I do know is that this mentality does not serve the investor and, as such, must
be discarded before we can attain to any lasting success. As evidence to this
fact, I offer the stories of some of our investment icons in days when they may
not have been so warmly embraced.
A Trip Down Memory Lane
Think
back, if you will, to 1974. If we put ourselves in that era, it’s been just 3
years since the dollar was removed from the gold-exchange standard, and our
national debt has already topped $474 billion. 1 The Arab Oil
Embargo is in full swing and Americans are waiting in long lines for gas as
prices continue to rise. Plans for busing black children to white schools in
Boston, has set off a series of race riots. Under intense public and
Congressional pressures, Richard Nixon has become the first President of the
United States to resign.
The
Dow has lost 45 percent, falling from 1051, in January of 1973, to 577, in
December of 1974. Fund managers, who had been eager to buy just a few years
earlier, have now taken a “batten down the hatches” approach to the markets.
Consider the words of Eric T. Miller, a manager at Oppenheimer at the time.
“I wish we could say that we have strong
preferences for areas that are unique right now, but we don’t, partly because
we don’t think it’s time to try to be a hero… to be terribly venturesome,
unless you could put me on [an] island and we were taking a three-year view.” 2
In
the same vein, Howard Stein, the Chairman of Dreyfus at the time notes,
“Price-earnings ratios, historic gains in earnings, projections of earnings per share, and many other analytical devices that you and I work with seem to have little relevance of late.” 3
In
the midst of all this, imagine that you’re shopping money managers. You’re
excited about one in particular, because you’ve heard he’s really good, but
he’s lost 23 percent in 1973 and he’s down 50 percent by 1974. Incredibly, as
the losses have mounted, he’s actually getting more confident!
If
we’re like most people, we’re thinking to ourselves, “If I invested $1 million
with this guy at the beginning of 1973, I’d have had $500,000 left by late
1974.” We extrapolate the current trajectory. “At this rate, I’ll be broke in 2
years! I don’t care how brilliant he thinks he is; I’m going pass on this one.”
“Oh,
that was Warren Buffet? Well, of course I would’ve stayed with him.” But, we didn’t know today’s story
at that time. Clearly, those who stayed with him and endured the losses over
those two years were handsomely rewarded.
“By early 1986, Berkshire had broken $3,000 a
share. In the twenty one years that Buffet had been turning the veritable dross
of a textile mill into gold, the stock had multiplied 167 times; meanwhile, the
Dow had merely doubled.” 4
Now,
if the only thing we learn from this story is that we need to go invest in
Berkshire Hathaway shares, we miss the point. This was yesterday’s story and
yesterday’s returns.
Over
the last 32 years, how much of every investor’s success has come from inflating
the money supply? Clearly to increase the money supply [and debt] in
circulation from $474 billion, in 1974, to $10.2 trillion, by March of 2006,
has influenced asset prices around the globe. Over the last two decades the Fed
Funds rate has been reduced from over 20 down to 1 percent. Clearly, this story
is not going to be repeated any time soon. This is the reality that all of us
must accept. The circumstances that helped make this possible, do not, and
could not, exist in our current economic and market environment. We would do
better to ask ourselves, “What things can we learn from this story that could
help us become better investors?”
In
the late 1990s, the “losers” were those managers who refused to index or to
benchmark their portfolios to the overall markets. In seeking to steer clear of
risky stocks and sectors that had become historically overvalued, their
portfolios “underperformed” the markets. It is not coincidental that, in 2000,
as the markets began their steep descent, these same portfolios “outperformed”
their benchmarks.
One
management company, which made the “mistake” of avoiding high-risk investments,
was considered by some of its institutional investors as a “loser” at the time.
During the 24 months leading up to 2000, this company’s assets under management
declined from $30 billion to $20 billion. Still, their unwillingness to
compromise and follow the herd, in the late 90s, proved a valuable asset. By
the end of 2004, their assets under management had grown to $75 billion. This
story, of the cash flows in to and out of GMO, shows us that even large
institutional investors tend to chase yesterday’s returns. 5
Michael
Covel’s book, Trend Following: How Great Traders Make Millions in Up or Down
Markets, focuses on trend following hedge fund managers. If the book title
sounds a bit out of your league, let me encourage you to read it anyway. The
knowledge and insights contained within would be benefit to investors at all
levels of the game.
One
of the managers discussed in Covel’s book is Bill Dunn, of Dunn Capital, who
manages over $1 billion for investors. Since first opening in 1974, his
long-term track record is enviable by any measure. However, Dunn has had
several drawdowns, (temporary losses). One such drawdown lost him his largest
client at the time. When asked how he deals with pressure from clients to
change how he trades, Dunn responded:
“A person must be an optimist to be in this
business, but I also believe it’s a cyclical phenomenon for several other
reasons. In our 18 years of experience we’ve had to endure a number of long and
nasty periods during which we’ve asked ourselves this same question [whether he
should change his model]. In late 1981 our accounts had lost about 42% over the
previous 12 months, and we and our clients were starting to wonder if we would
ever see good markets again. We continued to trade our thoroughly researched
system, but our largest client got cold feet and withdrew about 70% of our
total equity under management. You guessed it. Our next month was up 18% and in
the 36 months following their withdrawal our accounts made 430%!” 6
When
we read about successful investment managers like Buffet, Grantham, and Dunn,
we see vast differences in approach and one commonality. They were all willing
to accept short-term losses. Investors who looked at these losses, or periods
of underperformance (some of which lasted up to a couple of years), and decided
to sell, missed out on large gains in the years that followed.
And,
it’s not just individual and institutional investors who get this wrong. Again
and again, even the largest brokerage houses quite often make the same
mistakes. Consider the words of Barton Biggs in his new book, Hedgehogging.
Biggs, who recently retired from the position of Chief Global Strategist at
Morgan Stanley, spoke of the atmosphere at Morgan Stanley in the year 2000.
“Secular cycles, both in markets and sectors of
the market, make a big investment management firm a very conflicting enterprise
to manage if you are a businessperson, because the rational things to do to maximize short-term profitability are
exactly the wrong things from both an investment and a long-term profitability
point of view. For example, during 2000, even as the bubble was bursting,
Morgan Stanley Investment Management, which has a business-dominated
management, acted like businessmen: they heavily promoted the underwriting of
technology and aggressive growth stock funds because those were the funds the salespeople could sell and that the
public would buy. Management was not evil; they were doing what they
thought was right. Large amounts of public money were being raised and very
quickly lost. Short-term sales profits were collected at the expense of, not
only the public, but the firm’s long-term credibility and profitability.” 7
As
Biggs points out of the short-term focus at the top of a market, he also points
out the short-term view at market bottoms.
“The firm erred in the other direction in the
spring of 2003 when it shut down its
Asian Equity Fund, which it had invested exclusively in the Asia ex Japan
markets. The fund had shrunk from $350 million 10 years earlier when the Asian
Miracle was on everyone’s lips, to less than $10 million. At that level of
assets, it was a clear money-losing proposition, so it was the right,
short-term business decision to close it down. At the time, there didn’t seem
to be any interest in Asia. I argued vociferously to keep the fund open, and
maintained that, as the markets rallied, new assets would come. To no avail. No
one agreed with me, and the fact that they didn’t was a buy signal.” 8
In
April of 2006, the Asian markets of Singapore, India, and Hong Kong, are up 116
percent, 328 percent, and 94 percent (respectively) from where they were in
October of 2002.
It
should be plain to see that at every level of investing, we are our greatest
enemy. And while learning about ourselves as investors is one of the best
things we can do to ensure our success, this never has been, and never will be,
the primary message of industry marketing and media. As Biggs points out, there
are business decisions and investment decisions, and short-term business
decisions often seem to take precedence over long-term investment concerns. If
we are to become successful investors, we must understand our inherent
weaknesses as instinctual beings trying to ensure our (money) survival, and
continuously build our resolve to avoid the comfort that can only be found in
the herd.
This
predicament cannot be overstated. If we invest correctly, we most often take
actions opposite of the herd and usually experience temporary losses. We then
have to deal with strong instincts and emotions that shout to us, “You’re
wrong! Go back and do what everybody else is doing. They made money on their
last statement. They must be right!” To some extent, we all experience these
thoughts, and if we are to succeed, we must learn to overcome them.
So
now, we turn our attention to three character traits that we must develop to
increase our probability of long-term success in the game of money. I do not
expect that these tenets will produce a “Eureka!” moment for us, but we should
be warned: These views are easy to academically ascend to, yet nigh unto
impossible to sustain when we are experiencing strong emotional or mental
stress, such as the kind caused during periods of drawdowns.
To read the entire April Newsletter, you can sign up, at no cost,
through our website.
If you would like a copy of our research paper, Riders on the Storm:
Short Selling in Contrary Winds, visit our website. This will also
give you access to archives of the same monthly newsletter titled, The
Investors Mind: Anticipating Trends through the Lens of History.
Sources: