The Business of Investing
Dennis C. Butler, President
Centre Street Cambridge Corporation
Private Investment Counsel
of all guest columns written by Dennis C. Butler, CFA
We could be mistaken, but we get the impression that many market participants believe it possible for a smart investor to both take advantage of "irrational exuberance" and avoid the aftermath -- to capture the gains and not give them back, in other words. This is the theory behind "market timing," which seems to be gaining adherents as stock markets continue to head lower. No doubt some individuals have the knack or luck to make such wholesale moves in and out of securities, but recent history suggests that except for these fortunate few, this idea is nothing more than wishful thinking.
Two years ago, despite being hounded on all sides by clients, colleagues, Wall Street and the media, a few investors chose to ignore the siren call of the technology bubble. The reasons were several, and none of them involved clairvoyance or some uncanny ability to "call" market tops: tech companies were too complicated, their shares overpriced and their accounting often puzzling. In addition, experience and common sense taught the members of this experienced group that the optimistic expectations for technology, based as they were on boom-time economics, were unlikely to be realized. These investors, derided as overly cautious at the time, managed to avoid the ensuing collapse, but they also did not enjoy the renown some money managers gained with triple-digit returns made possible by speculative froth. The two do not go together, so it seems.
This is only half the story. Now, after the loss of $2.5 trillion in worldwide equity market value during the first half of this year alone, the shrewdness of these investors, in terms of what they didn't do in the late 1990s, appears enviable. What we find more interesting, however, is what they did do, since, ironically, the tech blastoff provided one of the most fertile grounds for productive investment activity in recent memory. Large numbers of non-tech businesses had been ignored and their stocks in some cases sold down to ridiculously low levels. Having little capital tied up in speculative technology issues, our "cautious" group was able to take advantage of ample opportunities for long-term investment in attractive businesses.
Last month the leading business journal drew attention to this apparently little-known aspect of the market declines of the last two-and-a-half years by pointing out that the very stocks that got carried away in the tech bubble are largely responsible for the declines in the major market indexes since, while the issues which the market rejected at that time have done quite well. While it is laudable for the journal to grant some recognition to careful investment techniques, oblique as it was, we find it regrettable that this was done in the context of offering a "potential lifeline" to those burned in the tech crash (referring to those stocks showing "relative strength" in the face of weak markets). Some of these "lifelines" have doubled and more in price since early 2000 and their purchase at current levels entails a different magnitude of risk than previously was the case.
Recent action offers further evidence that it may already be too late to hope for much help from this source. Even the winners that won notice in the journal article appeared to be faltering during the latter part of the quarter as an old-fashioned "bear market" arrived on Wall Street. Seemingly endless days and weeks of declines broadened to include more of the popular market indexes, producing the long faces commonly seen on the Street during such periods. While these are encouraging signs (to investors with cash, at least), the stock market remains generally uninteresting from a purely investment standpoint. This is partly a reflection of the extreme levels to which some stocks had been bid in early 2000, partly a result of the significant appreciation of so many neglected issues since. The accounting problems and management misbehavior that have come to light, involving some previously highly-respected corporations and individuals, are reminders that investing is a business where experience and judgement, not to mention caution, are valuable assets.
The Business of Investing
We find it instructive to examine the activities of the truly outstanding practitioners and thinkers in the investment field, past and present, for their insights into how superior investors managed to garner returns on their money that we lesser beings would be overjoyed to see from a distance. Unfortunately, few attain such heights, either because most who make the attempt do not really know how to approach the problem or, as is too often the case with money management professionals, because they are pressured into behaviors which are at cross purposes with professionals' advantages in information and skills. If you want a great investor's returns, you have to act like a great investor, and not like an amateur -- or a bureaucrat. Excellent investment results come from doing some things differently than the run-of-the-mill mutual fund, and sometimes in ways that seem counterintuitive.
Exceptional practitioners of the art of investment over the years have known that investing is a business, most successful when its operations follow careful procedures that are rooted in the character of the enterprise. In fact, investing has much in common with the merchandising trade: an inventory of goods is acquired which, it is hoped, can eventually be sold at a profit. A good merchant, like the wise investor, pays close attention to costs and is familiar with the nature of the market for the wares in which he or she deals. But the character of the investment business is like no other in certain important respects. Continuing with our merchandising analogy: the investor is like a merchant who is under no obligation to maintain a complete inventory of goods at all times. More unusual is the fact that, if so inclined, our investor-merchant can even choose not to do business with any customers at all!
Businesses typically tie up capital in plant or merchandise and other accounts on a continuous basis in order to satisfy the ongoing demands of commerce. Investing, however, has no such necessary and constant demands on its capital -- it is a different kind of business in which the volume of opportunities for the advantageous acquisition of "merchandise" ebbs and flows and at times dries up entirely. During the latter periods the careful investor may, in effect, close up shop for a while and place idle capital in short term instruments, maintaining the liquidity needed to acquire attractive assets when they inevitably do appear. Lacking good ideas, there is no need to engage in transactions just for the sake of looking busy.
This last point leads us to another peculiar quality of investing, a more psychological one. Not only are most other businesses scenes of constant activity, they are also hubbubs of excitement and competition, qualities which infuse most successful enterprises, instilling the drive to innovate, grow, and achieve the highest return on owners' capital. Careful investment shuns these emotions and the animal spirits associated with them, as enthusiasm in connection with securities usually means high prices and correspondingly diminished returns. This is why successful investors often look for their ideas in "dull" sectors of the business world, keep a low profile, and generally have little to say that is of much interest to the popular business media. Their investment operations tend to be quiet places, very unlike the images of rooms full of shouting traders that the public tends to associate with securities firms. It is not that careful investors lack competitive spirit (many are highly competitive individuals); rather their energies are directed toward goals beyond those of the fleeting moment that are the focus of most market players.
There is obviously more to being an outstanding investor than simply managing the business in the manner we have outlined, and the picture we have drawn is admittedly idealized. Nevertheless, it seems safe to say that the financial markets of the world are organized along lines quite different from our ideal, ones which cater to and promote the excitement of the chase. Likewise, we feel confident in concluding that the investment industry, with few exceptions, operates according to motivations very unlike those which are appropriate for the type of business it is in. Like it or not, we will have to accept the consequences, including hyperactive trading activity, a focus on short-term results, herd mentality, misallocation of capital, and the occasional speculative binge with its attendant scandal, fraud and -- sooner or later -- loss of wealth. As we recounted in our opening paragraphs, maintaining discipline in such an environment is difficult, indeed.
Our discussion of recent market history also demonstrated how modern financial markets, in their catering to foolish speculation, can be the true investor's friend. We remember well when people who should have known better argued that the Internet would ingest traditional businesses such as banking or retailing. It was difficult to convince such people otherwise in 1999 and 2000, but as we have seen since, the only ones who made money from such talk were stock promoters, insiders, and the lucky. Yet by denigrating the value of "old economy" businesses, opportunities were created that served investors well over the past two years.
Moving on, it is unclear to us whether or not the crushing rejection of technology and communications-related issues currently is a case of the pendulum's having swung too far, as some believe. In early 2000 the valuations of some traditional businesses were quite compelling. The depressed prices of many technology companies today still may not represent good value, especially in the case of companies whose actual earning power is a question mark because of "enlightened" accounting practices. What is clear to us, though, is the markets' continuing speculative character -- this time on the down side. Debating where the markets will bottom or whether there will be a "capitulation phase" are no better guides to investing money than betting on the future of some xyz.com start-up company. Urging investors to put their funds into small caps, mid-caps or gold shares -- among the few market sectors showing positive returns lately -- is merely latching on to what has been working: a common practice on Wall Street, but not sound advice. What is sound is to act according to the principles that flow naturally from the character of the investment business. Good results usually follow.
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:
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