Losers: Why We Invest With Them
[The following is an excerpt of our April newsletter. The entire newsletter is offered at no cost to those who subscribe through out website.]
By Doug Wakefield with Ben Hill
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.
2. Buffet: The Making of an American Capitalist (1995), Roger Lowenstein, page 157
3. Ibid, page 159
4. Ibid, page 275
5. Quarterly meeting with institutional investors, 4th quarter 2004, www.gmo.com
6. Trend Following: How Great Traders Make Millions in Up and Down Markets (2006), Michael W. Covel, page 39
7. Hedgehogging (2006), Barton Biggs, page 119 & 120
8. Ibid, page 120