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of all guest columns written by Dennis C. Butler, CFA
Early in the last century it was estimated that 90-95% of the share trading on the New York Stock Exchange was attributable to the activities of thinly-margined "operators" — in other words, small-time speculators who used mostly borrowed money to place bets on short-term moves in stock prices. Things probably are not that much different today; the borrowing is more tightly controlled, and the players are bigger, but the predominance of short-term trading remains. Consider the following: computerized trading schemes now regularly account for more than 50% of New York Stock Exchange volume on any given day. Despite unspectacular recent results, the ultra-glamorous hedge funds continue to grow in number and now control over $1 trillion in the U.S. alone. This "asset class" is not known for its patience. Even the relatively staid mutual funds lost their innocence long ago; from holding periods of several years during their youth 50 or 60 years ago, mutual funds nowadays freshen up their portfolios more than once per year on average (Judging by their results, increasing short-sightedness with age does not appear to have been accompanied by improved investment wisdom over the years.). Increasingly popular market vehicles such as ETFs (Exchange Traded Funds) seem mostly aimed at the speculative, trading-oriented crowd.
The Wall Street Journal recently provided an interesting insight into certain trading strategies employed in the stock market. Last Fall it was observed that movements in the stocks of two technology companies, Apple Computer and Google, became highly correlated with activity in an exchange traded-fund that tracks stocks in the energy sector. (The fact that someone actually does these types of studies is revealing in itself.) Displaying the quaint conceptual confusion typical of the financial media, the Journal attributed this phenomenon to the involvement of "speculative investors." Semantics aside, what these three securities had in common last year was the fact that all were rising smartly in price. This kind of action attracts interest from those who are attuned to "whatever seems to be working," as the article put it, thus reinforcing the trend. Note the lack of concern for actual investment merit. What happens when "whatever is working" stops working? Eventually the biggest fool finds out.
Stock indexes showed nice gains in the year's first quarter. In keeping with the "whatever works" train of thought, the volume of bullish chatter among commentators became noticeably louder over the time span. Enthusiasm over initial public offerings — usually a sign of optimism trumping experience — continued apace. Interest in foreign stock markets remained high, and insider selling continued to be active as well. Such is a sellers' market.
We found the bond market to be more interesting — at least from an observer's point of view. The worldwide sea of liquidity that we have previously examined continues to work to keep yields low and risks high. Returning to The Wall Street Journal : "Low quality corporate bonds are trading like they are almost risk-free...and investors are loaning money to companies with few constraints." Some loans have almost no constraints at all in cases involving so-called "covenant-lite" bond issues (covenants are investor-protection clauses that place financial restraints on bond issuers). Desperation for income in an historically low yield environment has permitted issuers and their promoters to get away with these deals that under more normal circumstances would be very difficult, if not impossible, to get done on such easy terms. Nevertheless, rates were rising during the quarter and corporations eager to lock in still-low financing costs continued to sell bonds at a record-setting pace.
We are convinced that this is not the time for anyone who values protection of capital to get involved with the "creative" financing of questionable issuers. Easy money creates a facade of safety that crumbles at any hint of danger. The time will come when risk is once again "priced in," and the owners of those "almost risk-free" bonds will discover just how quickly that process can play out. Of course, those participating in this game are aware of the risks, but the benign environment of recent years has created a lot of complacency. The failure of Federal Reserve actions to have much of an impact on longer-term bond yields also seems to have contributed to the sense of safety. Long-term rates unexpectedly fell when the Fed began to lift short rates almost two years ago. It suits our contrary nature to suggest that perhaps long bond yields will rise when the Fed is finished with its tightening policy. Wouldn't that be a surprise to a market expecting investment nirvana to arrive when the Fed is done!
Buffett On Investment Advisors
Warren Buffett's letter to shareholders of Berkshire Hathaway has long been favorite reading among investment cognoscenti, and it is usually well worth the wait for its annual appearance. Although not a new topic for him, this year Mr. Buffett's ire fell particularly hard on certain segments of the investment advisory (or "helper," to employ Buffett's term) profession. In particular, he focuses on "frictional costs" — the fees and transaction expenses incurred whenever someone entrusts the management of his or her wealth to another. Such costs subtract from the returns theoretically available to investors from the profits generated by businesses over time and are, Buffett maintains, excessive at perhaps 20% of business earnings in the aggregate. This is especially true in the case of the currently popular investment operations known as "hedge" and "private equity" funds which, in addition to the customary fees, also collect a percentage of profits (naturally, clients usually get to keep all of the losses).
We concur with all of Buffett's major criticisms. Costs are too high, especially when it concerns those oh so sophisticated hedge and private equity organizations, and activity — buying and selling — is far too frantic. Nevertheless, his analysis is incomplete. His broad and abstract view of the investment problem overlooks the valuable service that advisors can provide to non-professional investors. The middleman is hard to eliminate in this case. Investing involves specialized knowledge that is costly and time-consuming to acquire and will never be a simple product that can be purchased over the internet. As Buffett makes clear, it is the investment "helper" industry's unnecessary activity and marketing razzmatazz that is truly questionable and economically unjustifiable. These business practices have corrupted the profession and diverted it from its original mission.
It is not realistic to expect the average owner of capital acting on his or her own to be able to capture all of the future long-term rate of return from equity-type business investments (excluding dividends, that figure was about 5.3% annualized over the past century). Lacking the perspective of long experience and study, it is difficult to know how to go about this task. Even with some professional help individuals appear to have a hard time achieving acceptable results. One study showed, for example, that during a period when the Standard and Poor's 500 index returned 12.2% annualized, and the average equity mutual fund perhaps 10%, the average equity mutual fund owner enjoyed only a 2.6% result. As for "beating the market" — this questionable goal is beyond the reach of most players, including professionals. That this notion originally referred to someone who got involved in the stock market and managed to get out with his capital still intact is worthwhile keeping in mind.
It was for these reasons that the modern investment counseling and fund businesses came into being in the early decades of the last century, as a way to provide professional investment services to those with money and no knowledge of how to invest it properly — services previously available only to the very wealthy. To what extent has the original promise of this profession been fulfilled? If the figures quoted above are a reasonable indication of relative investment achievement over longer periods of time, then the industry overall has probably acquitted itself reasonably well, if not with Buffett-like results. Capturing 80% of market returns (10% vs. 12.2%) is certainly better than having to live with only 20% (2.6% vs. 12.2%). We are well aware that this view will be considered heresy in many quarters. Naturally, those who insist on having professionals "beat" market index returns will never be satisfied with such thinking (nor, one suspects, with their advisors).
Paradoxically, the very attempt to match or exceed an artificial index number may damage results in the long run. As a fund or money manager, what do you do when, as in the late 1990s, markets are outrageously overpriced, yet your bonus, not to mention your job, depends on how well your fund or clients perform versus an index? Career-determining choices like this are not easy to make and too often the decision is made to follow the path of least resistance and load up on risk — to do "what is working." As we saw in the current decade's early years, this route can ultimately have disastrous consequences for clients. The more difficult, correct choice is to stick with investment principles, protect client assets and forgo short-term relative results in favor of acceptable long-term returns. Investment counsel truly does a disservice to clients when it follows the dictates of internal business pressures instead of long-term client interests. To do well at investing, it is sometimes necessary to do poorly.
Finally, while it may be uncomfortable to do so, it is nonetheless important to point out that the onus for poor investment results does not rest entirely with the investment advisor. Owners of capital — large and small, private and institutional — can be their own worst enemies. As Mr. Buffett and everyone who has ever invested other people's money well know, one of the most frustrating impediments to good results has always been misunderstanding on the part of clients which has led to their interfering in the investment process, or to the firing of their advisors. The problem is closely related to the one discussed in the preceding paragraph, when pressures for performance are applied at the worst possible times, during periods of speculative excess. It is precisely during such times when patient and wise counsel is required, and also precisely when demands for results are at their highest and conflict most with that counsel. Counsel earns its fees at such times if it can persuade clients to avoid making foolish decisions. Whether by doing so it can enable clients to capture 80% or 100% of what the market offers seems less important than potentially avoiding disaster. Counselors who stuck by their guns, whether in 1929 or 1999, eventually proved their worth.
____________________
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:
Dennis C. Butler
President
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
Telephone: 617.441.9695
Email: cscc@comcast.net
URL: http://www.businessforum.com/cscc.html
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