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Commentary:
Bridging the
Performance Gap
October 2000
Dennis C. Butler, President
Centre Street Cambridge Corporation
Private Investment Counsel
See also:
General Index
of all guest columns written by Dennis C. Butler, CFA
The underlying dynamics of the stock market during 1998 and 1999 reminded us in some ways of the old Soviet Block countries whose showcase cities, such as East Berlin or Moscow, obscured to foreign visitors the true picture of a rather bleak countryside. Incredibly concentrated trading in a small number of popular issues impacted the major market averages in such a way as to create the impression that a great bullish advance was underway, when, in reality, in the great non-tech hinterland the silent majority of stocks declined and prospects seemed pretty dim. Hence, we are not especially surprised at the weakness in the market averages this year: just as the Iron Curtain charade eventually collapsed, the erstwhile market leaders have been suffering, removing the props holding up a bullish facade.
A brief summer rally provided some relief and brightened the hopes of Wall Street groupies throughout the land in August; but the Bears of April and May might as well have said "see you in September," as declines in the quarter’s final month returned the major stock market averages to the negative year-to-date trend that took hold in the spring. Rising energy costs and a declining European currency seemed to be the major sources of worry. Higher oil prices hardly seem surprising. There is a lead time between exploration and the appearance of new supplies on the market. Oil prices of $10 per barrel a couple of years ago didn’t exactly stimulate a lot of drilling, so the major oil companies are actually producing less now in a strong pricing environment than they did last year. Throw in a more disciplined OPEC and healthy demand growth, and suddenly you see the future of the world energy markets: with limited sources of new supply, a higher plateau for energy prices just might be in the cards. As for the Euro, Europeans have been big buyers of U.S. assets recently (to the tune of $140 billion in the third quarter alone), so higher demand from Euro holders for the dollars needed to make these purchases (and a weaker Euro) should not be surprising either.
Youthful Indiscretions
Leave it to Wall Street to come up with a turn of phrase such as "pump and dump." Colorful, yet illustrative of the exploits of a New Jersey youth who made use of his computer skills to tout stocks in Internet chat rooms (the "pumping" phase). Economics being what it is, the predictable increase in demand for those stocks from the bleary-eyed stock market junkies who inhabit such dens caused a spike in their prices, permitting our young operator to unload his previously acquired shares at a substantial profit for himself (the "dumping" phase). That his scheme employed stocks in such obscure and thinly-traded companies as Manchester Equipment Co., Fotoball USA, Inc., and Firetector Inc. -- not exactly household names ---demonstrates that he knew his stuff: it doesn’t take much interest to bring about big percentage moves in stocks such as these. Pumping and dumping , of course, is an old- fashioned game that pre-dates the computer age, and one that is subject to such Old Economy penalties as fines and jail. Seemingly unperturbed by the whole experience, our enterprising youth had to cough-up his winnings (some $285,000 -- no wonder kids don’t deliver newspapers anymore) and promise not to do it again. Curiously, he remains a hero to his high school peers, and his parents.That this precocious 15-year-old does not seem to be burdened with a great supply of innocence should serve as a warning to those of you who may be tempted to rely on the Internet for investment advice. Some reading his chat room messages thought they were getting straight poop from an experienced 40-year-old investor. Serves them right.
The Performance Gap
An article posted on one of the Internet stock market commentary sites caught our eye recently, as much for the mind-set it represented as the content of the story. The subject was the Sequoia Fund, an investment outfit run by very disciplined and competent people who have produced enviable results for their limited number of investors (the fund has been closed to newcomers since 1982) over their 30- year history of operations. Its investment approach is, in a way, limited, too: it invests in a small number of securities which it holds "forever."It was just such characteristics -- low turnover, long holding periods -- that came under fire in the article for being 'stodgy," "stagnant" and "frozen." These qualities, the author implied, accounted for the fund’s poor results: Sequoia "has underperformed the S&P500 for ten years," capped by an especially poor year in 1999 when it returned -16.5% versus a 21% gain for the S&P. Yet, the commentary continued, some recent transactions offer a "breath of fresh air" to shareholders who "have seen better days" due to a strategy that is out of date "in a changing stock market." Curious, we decided to investigate.
A quick perusal of Sequoia’s numbers since 1990 was intriguing: the fund’s results were, in fact, superior to those of the S&P every year save three, and only the large gap in 1999 brought its cumulative returns down to a below-S&P level, after having been substantially ahead of that index for the entire decade (at the end of 1998, for example, Sequoia’s annualized results over the period were 21.2% vs 17.9% for the S&P). Furthermore, Sequoia’s returns since inception in 1970 were 17.3%, annualized, to the S&P’s 14.6% over the same period -- not too shabby. We doubt if shareholders are very upset about a single year that probably doesn’t mean too much in the overall scheme of things.
The rather unsophisticated and shallow analysis of the Sequoia Fund in the article we have cited illustrates very well the image problems which investment operations like Sequoia have in a speculative market fascinated with some favored sector to the exclusion of others (for those of you not up on current affairs, it is now technology), and not prone to critical thinking. Shallow analysis abounds in the financial world, and results like Sequoia’s make for an easy target: in 1999, they trailed the S&P index by nearly 38%, setting back the fund’s cumulative returns relative to the market index over a long period of years. Nevertheless, a more thorough examination in such cases could prove revealing -- and profitable -- to those seeking to evaluate different investment approaches. Let’s continue with our look at Sequoia.
Past performance is no guarantee of future results, as they say, and one need look no further than Sequoia’s own record to find proof of this statement. 1999 was not Sequoia’s first poor year. Astoundingly (when viewed in light of its long-term record), the fund trailed the S&P during each of the first four years of its existence (excluding a partial year in 1970 when it also lagged the market index). At the end of 1974, Sequoia’s cumulative returns stood at negative 15.5%, compared to the S&P’s modest gain of 2.8% (1973 and 1974 were bad years for owners of equities). The author of the article we have been discussing, had she been observing the fund’s results at that time, would undoubtedly have concluded that something was dreadfully wrong at Sequoia.
Subsequently, the fund’s performance was subpar for two consecutive years in 1979 and 1980, and again in 1985 and 1986. It also experienced relatively poor results for each of the three years 1988-1990. During all of these periods, one could have asked the same question that is being asked now: is the fund’s "stodgy long-term buy-and-hold strategy" obsolete -- out of step with today’s marketplace? Historically, at least, the answer has always been no, and returns in subsequent periods more than made up for the lagging years. But since past results are no guarantee of the future, what is the outlook for Sequoia at this juncture? Have things really changed that much?
This is a judgement call that goes to the heart of all investment decision-making. In our view, the prospects for funds like Sequoia remain positive. The strength of its long-term results demonstrates the foolhardiness of simply dismissing a proven investment approach because of one year (or even two or three) of below-market returns. The fact that this strength is due not to a brief period of extraordinary gains in the past (indicating a flash-in-the-pan phenomenon), but is spread out over its history, is also encouraging. As for the unusual lag in 1999: as has been noted, 1999's market returns, as measured by the major indexes, were distorted by a heavy concentration of buying in very few stocks -- stocks of a type with which the fund will typically not get involved. These distortions masked a general decline in the values of most stocks. Sequoia’s results in this environment are not surprising or worrisome, nor are they, in isolation, conclusive when judging the competence of management or the long-term viability of their methodology.
Also significant is the presence of a stable policy that makes economic sense. Owners of businesses have accumulated great wealth in our society (they still do, even in the New Economy) and Sequoia’s buy and hold practice takes advantage of the economic factor that creates this wealth: good businesses tend to increase in value over time. On the other hand, the more active approach advocated by the Internet article is less viable, economically, since it increases costs (more transaction fees and taxes), while offering no evidence that long term results will be better. The fund’s relatively low fee structure (1% of assets) is also to the investor’s advantage. Finally, there is the issue of risk. A fund such as Sequoia, which holds long term positions in well-entrenched enterprises, would surely be considered less risky than one which follows the latest market fads, which is what is usually signified by the phrase "changing stock market."
The performance gap of 1999 affected many prominent, conservative investors, including the Sequoia Fund. But since the gap resulted from rampant speculation concentrated in a few issues that had an inordinate impact on the market averages, we are confident that it is a passing phenomenon that will, as in the past, reverse itself in due course.
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 23 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Telephone: 617.441.9695
Email: cscc@world.std.com
URL: www.businessforum.com/cscc.html
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Revised: January 3, 2001 TAF
© Copyright 2001 Dennis C. Butler, All Rights Reserved