Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
It suits our nature to "think tragically" (to borrow a phrase from author Robert Kaplan), i.e., to always wonder about what could go wrong. Even in the midst of good times -- especially then -- we steel ourselves for the inevitable disaster that always seems to strike when least expected. Not that we’re particularly gloomy -- we’re just skeptical and prefer to question the hype surrounding such popular notions as the New Economy, the "New Era" stock market or any other newness that claims to represent a radical break with past experience.
As long as you did not own one of the many individual stock disasters that blew up in their owners’ faces, there was certainly no radical break in the markets during the last few months. But there is plenty that could go wrong. Although technology shares continued their surge, driving the NASDAQ index up 12.4% since December 31, there were more than a few days when these shares stumbled badly, temporarily (thus far) inconveniencing the faithful followers of Silicon the Great. During one of those routs, certain tech-heavy mutual funds (and which ones aren’t these days?) dropped 15-16% in net asset value in the space of two days. This sort of action supports our view that there is just no "margin of safety" to cushion the blow of an enduring change of sentiment towards these stocks.
Neither do we buy the talk that today’s owners of equities (and they are at record numbers, by the way) are somehow more sophisticated than ever: long-term investors who will hold on through thick and thin and not panic at signs of trouble. We’ve seen enough fickleness already to dispose of such notions. The widespread abandonment of so-called "value" funds (forcing the managers of such funds to sell many holdings at bargain prices) is a perfect example. And value funds are guilty of nothing worse than producing flattish results in the face of a speculative market environment; it’s not as if they’ve lost gobs of money. Where is the patience that is supposed to get investors through really tough periods, when losses can be substantial? And what of "professional" money management that is supposed to protect individuals from their own worst habits? We’ve seen little evidence that professional fund management is much better overall. If anything, it focuses and intensifies the impatience and short sightedness that unfortunately characterizes the behavior of so many amateur market operators.
At The Beach
A friend of ours has for many years done well investing in "growth" stocks. Most recently he has taken a liking to the shares of certain technology companies selling at breathtakingly high valuations. "That’s the only place where you can find growth," he said at lunch recently (we didn’t have the heart to tell him he was echoing the siren call of certain Wall Streeters who have an interest in promoting such ideas). Even while admitting that there is a lot of risk in these stocks (he is prepared for a 50% drop, he says), he is determined to "ride the [technology] wave all the way in to shore." It was not surprising, therefore, when he said at parting, "let me know when you see the beach."
Problem is, there is no sure way of knowing when you are near the beach or whether there are dangerous reefs that might prevent you from reaching the safety of solid land. There is no stock market equivalent of a lighthouse or satellite positioning system that will permit you to pinpoint your location. If you are going to take huge risks and hope to be able to time your exit, you may as well be adrift on the open sea; your guess as to what will happen is as good as anyone else’s. Even if you guess correctly, it could very well be too late to profit and avoid shipwreck. In 1987, "portfolio insurance" was supposed to protect from a downturn, but by the time people realized how serious the decline was, few could benefit because everyone was trying to get out at once.
Stocks recovered following the 1987 Crash, but when you own securities that are valued, in some cases, at hundreds of times earnings, there exists the real possibility of permanent losses. In such cases, how do you know when a decline might be indicative of a potential problem, or just ordinary price fluctuation? Our friend is prepared for a 50% price drop, but then what? Does he take comfort in thinking that the decline has run its course, or does he fear further damage? Looking at a stock that sells for perhaps 50-100 times earnings even after a major decline, can he still be certain that the presumed growth rate supports such a price, or is the market trying to tell him something else? Our contention would be that there is no way to be sure. He could be correct in his expectations for growth, but the market may no longer continue to value such growth as fully as before. (It is useful to recall that it wasn’t so long ago when premiere growth companies were valued at ten times earnings or less.) The shareholder’s confidence must be severely tested under such circumstances.
As noted above, many fund investors have been jumping ship lately, having experienced that sinking feeling that comes when your neighbors’ stocks go up faster than yours. Emotionally, this may make sense -- after all, who wants to be the loser in the crowd -- but does it make sense economically?
Let’s examine what’ been happening. Disheartened by poor relative results, many individuals are withdrawing their money from underperforming mutual funds. Often such funds are specialized and have the ill fortune to be focused on an out-of-favor sector of the market. Other funds, however, may be diversified and have good long-term records, but their managers stick to their disciplines and avoid market manias such as the one that has taken hold in the technology area and sapped interest in the broader list of stocks. So, relative results falter, investors call it quits, and fund managers are forced to sell assets to redeem mutual fund shares. Prices of stocks in certain sectors such as small banks and industrial companies have become quite depressed due at least in part to such selling.
What are fund investors doing with their newly-raised cash? It would appear they are putting it into "hot" mutual funds, currently those with heavy exposure to popular market sectors such as the Internet and biotechnology. The hottest mutual fund group of them all, for example, was the beneficiary of fully one-fourth of the net new money flowing into funds during February of this year.
To summarize: what is happening is that fund "investors" are selling low and buying high. Common sense, not to mention ample empirical data, suggest that this is not a very wise thing to do. In fact, just the opposite course would be advisable. Why, after being disappointed with stodgy "Old Economy" types of investments, they now expect to be more successful in far riskier ventures is beyond us. We fail to see how people will profit from such a strategy over the long term.
In 1979, Warren Buffett wrote an article which outlined his reasons for believing that equity investments represented outstanding opportunities at that time. At about the same time Business Week magazine published a piece proclaiming equities a dying asset class. Three years later (after a period which included booms and busts in oil, gold, silver and other commodities and weak markets for most stocks) began the greatest bull market in stocks in history. Last November, Buffett, writing in Fortune, argued that equity owners should expect nowhere near the kinds of results in the coming decade or two that they have enjoyed since 1982. At the end of December, a Barron’s cover article, entitled "Warren, What’s Wrong?," dealt with Buffett’s failure "to adapt to the current technology-driven bull market," which has cost his Berkshire Hathaway shareholders dearly in terms of relative investment results. Being a controlling shareholder, Buffett still has his job while others who have failed to adapt have met unpleasant fates. A well-known fund manager and successful "value" investor was replaced by someone with a more saleable recent record. And at the end of the first quarter a prominent hedge fund manager closed his operations because he failed to understand a market that had become, in his words, "a Ponzi pyramid destined for collapse."
Buffett usually gets it right. Whether this time it will take three years to find out remains to be seen; with today’s technology, things tend to happen a lot faster.
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.
"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. 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
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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© Copyright 2000 Dennis C. Butler, All Rights Reserved
Revised: April 11, 2000 TAF
© Copyright 2000 Dennis C. Butler, All Rights Reserved