Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
Investing is a funny business, full of paradoxes and strange twists that often confuse and mislead newcomers. Even casual observers are probably familiar with the contrary market behavior often associated with good economic news, and vice versa. Those experienced in the ways of Wall Street also know that being early and being wrong look the same. Mistakes and opportunities can also look very similar. Perhaps oddest of all — in order to do well, you have to do poorly. The failure to understand this — one of the most basic facts of investment life — is probably the single most important cause of genuinely poor results, excessive risk-taking, high costs, and wasted brainpower in the investment business.
Doing well by doing poorly is not as paradoxical an idea as it may seem at first glance. What we really mean is, it is sometimes necessary to do poorly in the short run in order to do well in the long run. At this point it is essential to emphasize that it is the long run which concerns us as investors in securities such as common stocks. When of necessity the focus is on the short term, the emphasis should be on safety and stability — money funds, treasury bills and such. Short-term thinking involving what should be long-term assets like stocks leads quickly into the realm of speculation, and practices which are not conducive to building value over time — not to mention posing an immediate risk to capital — for most who engage in those activities. These are critical distinctions when thinking about investments. Their examination provides insights into what we might consider the appropriate "investment temperament," and reveals what is really meant by "doing poorly" in the investment context.
Extreme examples frequently help to clarity issues concerning investment thinking and practice. Let's take the NASDAQ market in 1999, a year still living in the memory of most current market participants. In that year the NASDAQ Composite stock index returned an incredible 85%. Imagine being in the position of having to think short-term, with the goal being to match or beat this index on a year-to-year basis (a job description commonly found in the fund management business)! Your choices are few: you either buy an index fund, or load up on some of the most popular technology names of the day. Failure to do so will most likely cause you to seriously "underperform" the NASDAQ index (and, if you are an investment professional, most of those with whom you are in competition) . In reality , either choice made you a wild-eyed speculator. At the beginning of 1999 the NASDAQ stocks were seriously overpriced — at year-end, absurdly so. Acquiring exposure to the NASDAQ index stocks at the beginning of that year was simply making a wager that the market's momentum would carry the day despite the risk. The bet worked in 1999.
It was possible to view the same situation and choose an entirely different course of action. True investors recoiled in horror at the idea of making such an outrageous wager, knowing that, in the long run, such moves would almost certainly undermine the investor's duty to preserve capital. Their refusal to play this game meant they would underperform the NASDAQ and do poorly relative to speculators. It goes without saying that such a move would be considered suicidal in the money management and mutual fund crowd. Nevertheless, it was unavoidable for the true investor, who, by definition, must think beyond the short term. One year's "underperformance," as we now know, paid off handsomely soon thereafter, as it turned out, as the investor avoided the NASDAQ collapse after 1999. Furthermore, those who made sensible choices during the boom years of the late 1990s (for which they were roundly condemned at the time) enjoyed sizable gains in the new decade. "Doing poorly ," in the context of the investment business, is seen for what it really is — a relative concept having more to do with short-term competitive pressures than real investment considerations. The actual paradox is that really doing poorly in investing is often an outcome of not being willing to "do poorly"in the short-term, and relative to others who take undue risks.
Investing demands consistency in the rigorous application of analytical tools and decision-making criteria, or, as a leading investor has put it, operating within a "sound intellectual framework." Interestingly enough, investing, when conducted along these lines, is an activity that essentially governs itself. The work of the investor is to a large extent concerned with just two things: the price of an asset and its underlying value (note that this is not simply a matter of so-called "growth" and "value" stocks or appraoches). There are times when opportunities abound and the difficulty lies in selectmg the best from among many alternatives. This cheerful type of environment is typically found during depressed markets, or during market aberrations, such as that which occurred during the late 1990s dot-com boom, when attention and money was focused on a few favorite companies and sectors, while a broad spectrum of securities was being ignored. In-between times are like Goldilock's choice of porridge — neither hot nor cold. Opportunities are fewer, though not especially rare, and investment activity slows. Finally, there are times when investment opportunities are few and far between. Investors are seldom active during these periods; however, the fillancial markets are far from quiet — Wall Street is in the news, trading very heavy, and prices high and rising. At such times the temptation to speculate is greatest, middlemen and deal makers get rich, and dealing in securities seems an easy way to wealth.
For the investor who has consistendy followed sound principles, wonderful things tend to happen during the latter frothy periods. Having built a portfolio at advantageous prices, whether during depressed markets or as individual opportunities appeared from time to time, the investor can now reap the rewards. Security prices rise strongly. Credit tends to be plentiful, feeding merger and acquisition activity that may liquidate holdings advantageously. Solid business conditions and bright prospects lead companies to increase dividends or announce share buybacks. Having fewer opportunities to commit capital, the investor's cash reserves tend to rise, providing a cushion for the inevitable downturn to come, and firepower to use when favorable buying conditions return. The investor doesn't have to anticipate market moves or make predictions of any sort, and rapid turnover of portfolio holdings to capture expected price changes is unnecessary. The cycie lS self-regulating, both enriching and protecting the investor during unruly periods, and providing the resources for advantageous moves during favorable times — provided, of course, that principles are consistendy applied with a long-term perspective. "Poor" short-term performance is not an issue.
The point of this discourse on investment method is twofold. Firstly, we seek to put the current business and financial climate into perspective. Business has enjoyed an extraordinary period of prosperity in recent years. Profit margins are the highest in history. Record profits and cash flows have been used to repair balance sheets, and also to enrich shareholders by boosting dividends and, increasingly, buying company shares in the open market. Credit has been unusually plentiful and cheap. Abundant funding has supported record levels of merger and acquisition activity and financed even the most questionable of credits, as well as fostered all sorts of financial ingeniousness. The largely unseen — but huge — meta-markets of derivatives and other obscure financial engineering creations, inhabited by hedge funds, brokers, banks, and other nebulous players, are attracting unprecedented amounts of talent and money. For the investor who has been accumulating assets over and for the long-term, it's payoff time. All of this activity has increased the value of those long-term commitments, and increased the cash return on investment as well.
Secondly, we want to propose an investment stance appropriate for current conditions. While the long-term investor has been doing well on "seasoned holdings," what to do with growing cash inflow represents a quandary. Newly arrived investors with significant cash hoards face an even greater challenge as the self-regulating machinery of investing limits what can be done. It is difficult to find attractive investment ideas. The same rising prices and robust markets that have enabled the investor to benefit from long-term commitments has made the "expected returns" on new investments unattractive. Indeed, a time of "poor" results is definitely upon us. But this is a natural part of the cycle that will eventually run its course. In the famous words of J . P. Morgan: "The markets will fluctuate."
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The financial markets during the fourth quarter of 2006 were no land of opportunity for investment, although existing holders enjoyed a fun ride. Stocks, as reflected in the popular indexes, continued an impressive rise that began in mid-summer, adding another 6.5% or so to earlier gains, making for totals of from 16% to 19% during a volatile year. Demand for bonds also remained strong and the "inverted yield curve," in which shorter term yields exceed those of longer maturities, remained in place at historically low levels of interest rates. Calm returned following several months of uncertainty earlier in the year, and at year-end volatility was low and optimism growing. Against a background of record trading volumes, a reviving market for initial public offerings, and talk of the first $100 billion leveraged buy-out, Wall Street houses handed out over $20 billion in bonuses to their staffs. Small wonder that "Feed the birdies when they are hungry" is an old Wall Street saying.
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.
"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 2007 Dennis C. Butler, All Rights Reserved
Revised: April 16, 2007 TAF
© Copyright 2007 Dennis C. Butler, All Rights Reserved