Some thoughts on choosing investment managers

Last quarter we discussed some of the factors that seem to mark a good investment manager such as a sound discipline, effective risk control, avoiding conflicts of interest, low turnover, etc.  Unfortunately, most investors choose a manager based mainly on recent performance - especially performance relative to the market.  This can be a dangerous approach as it is unlikely that any manager can outperform continually.  Furthermore, this may actually be undesirable!  What we mean is that to attempt such a feat may lead one away from long term superior performance.  If you want to beat the market, you cannot look like the market.  If you don’t look like the market there will inevitably be periods where you underperform the market.  So, perversely, periodic underperformance may be a necessary pre-requisite to long term outperformance!  Warren Buffet doesn’t compound his assets every month/quarter/year at a constant 30% rate.  He successfully avoids large losses, while compounding at average rates, and then occasionally he makes a big score.  Not long ago buffet was attacked in the financial press for having lost his touch.  It seemed he just didn’t ‘get it’ – the new era of tech, that is.  By avoiding the area of excess he suffered the shame of ‘underperformance’ even while he was generating nice absolute returns.  More importantly, by avoiding the area of excess he also avoided the large losses that were to come.  It was this willingness to underperform that lead to his long term superior record.  Disappointing performance was likely a necessary pre-requisite to superior performance. 

To flesh this out further, we turn to some data provided us by our friend George Sertl.  According to George, some of the best mutual funds out there frequently underperform the S&P 500 and sometimes have multi-year stretches of underperformance.  For 34 years the Sequoia Fund delivered a compound return of 16.5% per year, well ahead of the S&P 500 at 12%.  Yet, they underperformed the market for 14 of those 34 years, or 41% of the time!  The Windsor Fund (under John Neff) and the Clipper Fund also soundly beat the market over very long periods, yet they underperformed 37% and 50% of the time respectively.  Clearly, outperforming the market each month/quarter/year is not necessary to achieve long term outperformance.  Furthermore, we would guess that these funds focused mostly on generating good absolute returns and avoiding large losses.  Outperformance was likely not a major focus in the short run but was achieved in the long run. 

Here is another common theme among the great investors.  They don’t act until the situation is favorable.  When the odds are poor they are idle.  When the odds are attractive they are active.  Counting cards in Blackjack is similar.  Occasionally the cards remaining in the deck create very favorable odds for the player.  During these times you bet heavily.  During the inevitable periods where the odds favor the house, you bet minimally.  You bide your time.  You want to still be in the game when the favorable odds come your way again.  So too with stocks.  Sometimes the vast majority of stocks are offering a poor risk vs. return tradeoff.  That is, the odds are stacked against you. This doesn’t mean that stocks won’t rise, only that the likelihood is for a small gain or a big loss.  This brings us to another key to creating a superior long term record.  Don’t do anything stupid.  Don’t take a big hit.  A large loss is very hard to recover from.  When the opportunity for gains is poor, be conservative.  When the opportunity is great, take full advantage.  Such opportunities are infrequent and you cannot force them to arise by trading more. 

We realize that all of this just makes it that much harder for an investor to know which manager to choose.  How long do you stick with an underperformer?  How do you know when to cut your losses?  We have no easy answers.  Contrary to the claims of many best selling investment books, there are no “7 easy steps to financial freedom”.  The investment business does not have a simple formula which can be entered into a computer to give us successful buy and sell directives.  The human element is critical to understanding markets.  Markets are simply groups of people. And people are fallible.  We sometimes do irrational things and frequently make mistakes.  Our best suggestions:  First, make sure you have chosen a strategy that fits your personality.  If you are a Type A person who tends toward hyper-activity, you may not be able to stick with a low turnover, value-type strategy long enough to allow it to work.  Second, choose a manager whom you believe, understand, and trust.  And check him/her out.  Look for a manager who can explain what he is doing and why.  Good communication is essential.  Third, get an explanation of the performance record.  Why did the manager underperform in this period?  Why did he outperform in that period?  Make sure the manager has a sound investment discipline as well as the confidence to stick to it through full cycles. 

Savers cheer, debtors tremble

The Federal Reserve has given savers cause for celebration.  Maybe, just maybe, the assault on savers is fading.  The Fed has begun the process of raising interest rates.  With the Fed Funds rate at 1.25%, it is still well below recent inflation levels of about 3%.  Thus, the rate is still artificially low, forcing savers to continue to subsidize borrowers and conservative bond investors to increase their risk to maintain their income.  The quarter point increase is not large enough to mean anything to anybody.  Yet it gives us hope that short rates will rise from their artificially depressed levels.  In fact, rates are rising around the world.  Even here in the US, the bond market has pushed rates significantly higher in recent months, perhaps fearing that the Fed has been too inflationary. 

The Fed certainly must see that the world has become addicted to low interest rates.  This is why they have been so careful to prepare us for the tightening phase.  They know that easy money is the golden goose for debtors and they are loathe to kill it.  However, slowly, grudgingly, the Fed will be dragged along on the path to less stimulative monetary policy.   A restoration of more normal interest rates will once again encourage people to save and invest instead of to borrow and spend.   

The Portfolio

The market has lost its appetite for risk.  The most risky assets that performed so well in 2003 seem to be losing their luster.  It will not surprise anyone to find that we are positioned defensively; at least as defensively as we can manage in this market of speculators.  Today, everybody is a speculator, every asset is a speculation.  Old fashioned investors and investments alike are in short supply.   

There were a few changes to the portfolio during the quarter.  We rebuilt our position in Mattel.  Approximately a year ago we trimmed our position by half when the stock price passed $21.  Since then, sales have been disappointing for several product lines, most notably the Barbie line.  For the last couple of years the company management has been largely focused on turning the company around by exiting poor performing businesses and through dramatic cost cutting.  This has been very successful as evidenced by the restoration of the earnings level.  Now management must focus on growing revenues.  We have faith in the capability of management as well as the strength of brands such as Barbie, Hot Wheels, Tyco, Fisher Price, etc.  We increased our holding to 4% of the portfolio at $16.99 and estimate fair value in the neighborhood of $25. 

The Northeast Investors Trust junk bond mutual fund was sold during the quarter.  We think very highly of the management of this fund but we have grown increasingly uncomfortable with the asset class.  As we have discussed, the last year has been one in which investors have embraced risk.  Interest rate spreads have shrunk and junk bond issuance has flourished.  Everywhere you look, risk premiums are shrinking.  While an unconventional holding for a mostly-equity-fund, it has been a good choice.  For the last three years, it has returned +6% per year.  For comparison, our main benchmark, the S&P 500, has lost -.8% per year. 

The funds from the sale of the Northeast Investors Trust where used to purchase stock in Ensco (ESV) and Bristol-Myers (BMY).  Ensco is an oil service company, a driller.  Our views on this sector were covered in last quarter’s newsletter.  However, we would like to point out that even with the price of oil rising rapidly, most of the oil service stocks have appreciated very little.  Therefore, there appears to be little downside if the price of oil falls significantly, while there should be good upside to the investment if the price of oil should remain fairly high for an extended period as we suspect it will.   

We have had a half-position in Bristol-Myers for a couple of years now.  At this point, the problems of the company, and industry, namely a loss of patent protection on many products, are well known and hopefully well discounted in the price.  In such an expensive market as this, BMY is an exceptional value.  The stock is trading at 15x trailing earnings, well down from peak earnings, and has a 4.6% yield.  We think the stock will sell for north of $40 in the future as new products are developed. 

Being a Contrarian

As we have discussed at length in the past, most investors have come to view cash as the least desirable asset to hold.  In retrospect, considering that the Vanguard 500 Index fund has returned a negative 2.26% per year for the last five years, cash doesn’t look so bad.  Perhaps the only asset more ridiculed than cash in recent years has been gold.  It is interesting then that the Tocqueville Gold fund has returned +23.3% per year for the last five years.  These are classic examples of contrarian investing.  Buying the most out of favor asset class can sometimes deliver fantastic returns.  However, it is very hard to buy something that everyone “knows” is a loser.  Being a contrarian investor is not easy. 

We want to thank you for your business and assure you that we will continue to watch over your money as carefully as we watch our own.

 Sincerely,

Clayton Bryan, CFA                                        Doug Manz, CFA

Principal                                                                      Principal

*This letter is for informational purposes only.  Nothing contained herein shall be construed as an offer or recommendation to buy or sell individual securities.  Data has been obtained from sources believed to be reliable but there can be no guarantees concerning errors or omissions.