Cynic, n. A blackguard whose faulty vision sees things as they are, not as they ought to be.
Ambrose Bierce
One of the joys of having entered the investment business in the 1980’s is that you came in at a time when the profession was still populated by some really nice and thoughtful people, well-read and curious about the world around them. They were and are generally willing to share their thoughts and ideas without hesitation. They were the kind of people that you hoped you could keep as friends for life. One such person is my friend, Bruce, who had a thirty-year career on the “buy side” as both an analyst and a director of research at several well-known money management firms. He retired in 2008 and divides his time between homes in western Connecticut and Costa Rica.
Here in Chicago in January, with snow falling again and the wind chill taking the temperature below zero, I see that Bruce, sitting now in Costa Rica, is the smart one. Then I reflected on a lunch we had on a warm summer day last August near the Mohawk Trail in western Massachusetts. We stay in touch regularly but this was the first time the two of us had gotten together in several years.
The first thing I asked Bruce was what he missed most about no longer being active in the business. Without hesitation he said that it was the people. For most of his career he had interacted daily with other smart investors as well as company management teams. You learned how they thought, what kind of people they were, whether they loved their businesses or were just doing it to make money, and how they treated their shareholders and investors. Some of his best memories were of one-on-one meetings or small group dinners. These were events that companies used to hold for their institutional shareholders. That ended with the implementation of Regulation FD (full disclosure), the purpose of which was to eliminate the so-called whisper number that used to be “leaked” to certain brokerage firm analysts ahead of earnings reporting dates. This would allow those analysts to tip-off favored clients, giving them an edge in buying or selling a position. Companies now deal with this issue by keeping tight control on investor meetings and what can be said in them, tending to favor multi-media analyst days (timed, choreographed, scripted, and rehearsed events where you find yourself one of three hundred in a room being spoon-fed drivel), and earnings conference calls (timed, choreographed, scripted, and rehearsed events where you find yourself one of a faceless mass listening to reporting without seeing any body language). Companies will still visit current and potential investors by means of “road shows” run by a friendly brokerage firm coincidentally looking for investment banking business. But the exchange of information can be less than free-flowing, especially if the brokerage analyst sits in on the meeting. And, to prevent accidental disclosure, the event is still heavily scripted. It has however created a new sideline business for brokerage firms in these days of declining commission rates. Even if you are a large existing institutional shareholder, the broker/investment bankers think you should pay them $10,000 – $15,000 in commissions for the privilege of seeing the management of a company you already own. This is apparently illegal in the United Kingdom, and referred to as “pay to play” there. Here, neither the SEC nor the compliance officers have tumbled to it as an apparent fiduciary violation.
Next I asked him what had been most frustrating in his final years. Again without hesitation he said that it was difficult to feel that you were actually able to add value in evaluating large cap companies, given how the regulatory environment had changed. I mentioned to him that everyone seemed to be trying to replace the on-site leg work part of fundamental analysis with screening and extensive earnings modeling, going out multiple years. Unfortunately many of those using such approaches appear to have not learned the law of significant numbers in high school chemistry. They seek exactitude while in reality adding complexity. At the same time, the subjective value of sitting in a company headquarters waiting room and seeing how customers, visitors, and employees are treated is no longer appreciated.
Bruce, like many value investors, favors private market value as the best underpinning for security valuation. That is, based on recent transactions to acquire a comparable business, what was this one worth? But you need an active merger & acquisition market for the valuation not to be tied to stale inputs. He mentioned that he had observed the increased use of dividend discount models to complement other valuation work. However, he thought that there was a danger in a low interest-rate environment that a dividend discount model could produce absurd results. One analyst had brought him a valuation write-up supported by a dividend discount model. Most of the business value ended up being in the terminal segment, requiring a 15 or 16X EBITDA multiple to make the numbers work. Who in the real world pays that for a business? I mentioned that Luther King, a distinguished investment manager in Texas with an excellent long-term record, insisted on meeting as many company managements as he could, even in his seventies, as part of his firm’s ongoing due diligence. He did not want his investors to think that their investments were being followed and analyzed by “three guys and a Bloomberg terminal.” And in reality, one cannot learn an industry and company solely through a Bloomberg terminal, webcasts, and conference calls.
Bruce then mentioned another potentially corrupting factor. His experience was that investment firms compensate analysts based on idea generation, performance of the idea, and the investment dollars committed to the idea. This can lead to gamesmanship as you get to the end of the measurement period for compensation. E.g., we tell corporate managements they shouldn’t act as if they were winding up and liquidating their business at the end of a quarter or year. Yet, we incent analysts to act that way (and lock in a profitable bonus) by recommending sale of an idea much too early. Or at the other extreme, they may not want to recommend sale of the idea when they should. I mentioned that one solution was to eliminate such compensation performance assessments as one large West Coast firm is reputed to have done after the disastrous 2008 meltdown. They were trying to restore a culture that for eighty years had been geared to producing the best long-term compounding investment ideas for the clients. However, they also had the luxury of being independent.
Finally I asked Bruce what tipped him over the edge into retirement. He said he got tired of discussions about “scalability.” A brief explanation is in order. After the dot-com disaster at the beginning of the decade, followed by the debacle years of 2008-2009, many investment firms put into place an implicit policy. For an idea to be added to the investment universe, a full investment position had to be capable of being acquired in five days average trading volume for that issue. Likewise, one had to also be able to exit the position in five days average trading volume. If it could not pass those hurdles, it was not a suitable investment. This cuts out small cap and most mid-cap ideas, as well as a number of large cap ideas where there is limited investment float. While the benchmark universe might be the S&P 500, in actuality it ends up being something very different. Rather than investing in the best ideas for clients, one ends up investing in the best liquid ideas for clients (I will save for another day the discussion about illiquid investments consistently producing higher returns long-term, albeit with greater volatility).
From Bruce’s perspective, too much money is chasing too few good ideas. This has resulted in what we call “style drift”. Firms that had made their mark as small cap or mid cap investors didn’t want to kill the goose laying the golden eggs by shutting off new money, so they evolved to become large cap investors. But ultimately that is self-defeating, for as the assets come in, you either have to shut down the flows or change your style by adding more and larger positions, which ultimately leads to under-performance.
I mentioned to Bruce that the other problem of too much money chasing too few good new ideas was that it tended to encourage “smart guy investing,” a term coined by a mutual friend of ours in Chicago. The perfect example of this was Dell. When it first appeared in the portfolios of Southeastern Asset Management, I was surprised. Over the next year, the idea made its way in to many more portfolios at other firms. Why? Because originally Southeastern had made it a very large position, which indicated they were convinced of its investment merits. The outsider take was “they are smart guys – they must have done the work.” And so, at the end of the day after making their own assessments, a number of other smart guys followed. In retrospect it appears that the really smart guy was Michael Dell.
A month ago I was reading a summary of the 2013 annual investment retreat of a family office investment firm with an excellent reputation located in Vermont. A conclusion reached was that the incremental value being provided by many large cap active managers was not justified by the fees being charged. Therefore, they determined that that part of an asset allocation mix should make use of low cost index funds. That is a growing trend. Something else that I think is happening now in the industry is that investment firms that are not independent are increasingly being run for short-term profitability as the competition and fee pressures from products like exchange traded funds increases. Mike Royko, the Chicago newspaper columnist once said that the unofficial motto of Chicago is “Ubi est meum?” or “Where’s mine?” Segments of the investment management business seemed to have adopted it as well. As a long-term value investor in New York recently said to me, short-termism is now the thing.
The ultimate lesson is the basic David Snowball raison d’etre for the Mutual Fund Observer. Find yourself funds that are relatively small and independent, with a clearly articulated philosophy and strategy. Look to see, by reading the reports and looking at the lists of holdings, that they are actually doing what they say they are doing, and that their interests are aligned with yours. Look at their active share, the extent to which the holdings do not mimic their benchmark index. And if you cannot be bothered to do the work, put your investments in low cost index vehicles and focus on asset allocation. Otherwise, as Mr. Buffet once said, if you are seated at the table to play cards and don’t identify the “mark” you should leave, as you are it.
Edward Studzinski
