Centre Street Cambridge Corporation

Private Investment Counsel


October 2003

Ecce Speculatio*

We had to fight back tears of joy—the first television advert for day-trading we had seen in over three years! Seeing this ad for “educational” seminars, featuring crowded lecture halls full of smiling couples eager to learn everything they needed to know to make money in stocks, awakened a yearning for the good old days, when “dotcom” was de rigueur, and 20 percent annual returns were thought pathetic. Images from the Great Bubble danced before our eyes, so vivid we could see the stock price charts glowing on computer monitors. Alas, after regaining our composure and critical faculties, we noticed that the commercial never mentioned that no one makes money at this crapshoot except, of course, the obliging brokers executing the transactions. Absent, too, was any reference to the bankruptcies among day traders that accompanied the collapse of the speculative frenzy after its height in early 2000. It just goes to show that when it comes to rampant stock speculation, it’s not what you know, or whom you know, but what you don’t know that counts—and it’s going to hurt you. Actually, “speculation” is too good a word to use in this context. The great speculators of old employed a better term to describe people who did these things—“suckers.”

It is not especially surprising to see the gambling spirit return to Wall Street, and not just among the rubes: money managers are at it, too. This is just what happens after an extended rise in stock prices. In contrast to old age, which robs us of short-term memory, the longer a market rally goes on, the more impaired becomes long-term memory and the perspective it affords. Quickly forgotten are the perils and ultimate consequences of blind risk-taking, as long as those around you are making money in the here and now.

The perils seem to us to be as great now as at any time over the past twenty years. One can point to currency issues, trade imbalances, heavy indebtedness, political instability, terrorism—just to begin a list of potential problems, any of which could have an unexpected impact on the financial markets. As investors with a keen awareness of possible consequences and an interest in preserving capital, we view these matters with great concern. Compounding our challenge is that we are simply not being offered a sufficient reward for taking on these risks. With stocks trading at eighteen to twenty times expected earnings on average (with some popular groups at much higher valuations), there is slim margin of safety to be found in those assets. Bonds, too, are expensive at prices not seen in a couple of generations. In fact, bonds offer a glimpse of what could be in store for the unwary. Buyers of longer-term, “risk-free” government securities last June are now facing paper losses of about 10 percent, more than offsetting their meager 3 percent coupon yields. Conceivably, buyers of the longest-maturity bonds may be facing the prospect of capital losses for decades to come. As one well-known investor once said: “Never a long-term lender be.”

But who needs safety when you are having fun? The markets continued to provide plenty of that. Depending on your favorite index, stocks returned from 2 to 10 percent in the third quarter, and were up from 11 to 34 percent for the year so far. If this keeps up even “cautious” market participants may be tempted to throw in the towel as the pressures for “performance” grow. But a word for the wise: certain highly successful practitioners are known to be sitting on piles of cash.

Warren Buffett, for example, had about $28 billion at last report. Mr. Buffett has sometimes been accused of being behind the times, but he has a long-term memory to match his long-term investment record. While he has been known to make mistakes, they are few—very few. Besides, only in the mind of an index-clinging mutual fund jockey could holding cash be considered a mistake. What could Buffett lose if he is wrong—his capital?

Performance Attribution

The institutional investment crowd—portfolio managers, fund companies, pension fund sponsors, and their gnat like consultants—have a keen interest in analyzing how they achieved their investment returns. In a process known as “performance attribution,” elaborate statistical studies are run to discern whether results were due to luck, manager skill, emphasis on a particular industry group, or other factors. We are sure all of this work is highly interesting, but in keeping with a modus operandi that is the scourge of institutional investing, it is done on a very short-term basis (just how short we do not know, as it has been a long time since we were privy to institutional operations; but we have seen such people obsess on daily results.). We tend towards a broader view of these matters. As we see it, the results that an investor achieves over his or her lifetime can be seen to derive from two primary sources: first, the opportunities that the market presents during one’s investment career; second, one’s ability to take advantage of those opportunities. The availability of prospects for investment is something beyond our control—it represents the cards that fate has dealt us during our time, much dependent on economic conditions, political and social attitudes toward business ventures, and so on. In our society (at least for the last century or so), opportunities for investment have been relatively abundant most of the time.

Fortunately, the ability to capitalize on investment ideas is something we can at least influence. This capability, likewise, has two attributes, the first being the Janus-faced quality that is a combination of intelligence and experience. Intelligence can certainly be a plus in the investment enterprise, but there are intelligent unsuccessful investors, and successful ones of good, but not unusual, cognitive prowess. The kind of intelligence that produces Nobel prizes often goes astray in the field because laureates have a tendency to venture down paths unrelated to real investment issues (a poet once said of certain painters that they depict not realism, as they claimed, but only those components of reality that pleased them). By contrast, investors acting intelligently tend to stick with what is relevant and important, and exclude non-issues (market forecasts, trading volume statistics, price chart patterns and such)—things that are deemed so important by many on Wall Street.

What is relevant to investing is derived from its nature as a business; as such, experience is probably and properly of greater weight in determining success. Investing, like many businesses (retailing is an obvious example), is focused on the values and prices of goods (securities in this case), and how those values and prices change over time. Experience with these changes is essential to having a proper perspective on the business and to being able to identify opportunities when they arise. Turning to the retailing analogy, this is not unlike, say, a buyer for a department store who seeks to keep abreast of fashion trends in order to be able to capitalize on an expected surge in demand for certain items of clothing. In fact, the processes behind investing often have been compared to retail enterprise with its flow of inventory and profits.

If intelligence tempered with experience enables us to identify investment prospects, it is the availability of capital that allows us to profit from them. We are not referring to simply having funds to invest (that is assumed), nor are we advocating the flawed theory behind “market timing”—selling high so you have the funds with which to buy low. What we are referring to, instead, is activity guided solely by a focus on investment principles, in order to avoid silly errors that fritter away capital and erode returns. Recent reports revealed the extent of this problem: few mutual fund holders were found to have profited to any significant degree from the long bull market in stocks of the 1980s and 1990s. The silly error in this case was the tendency to switch funds too often, and chase after those with the hottest records.

But lack of adherence to investment precepts is not confined to inexperienced retail fund customers. Indeed, it is a chronic problem in the investment industry itself as it grapples with unholy institutional imperatives that distract it from the true path. The so-called performance derby lies at the heart of this issue. Why else would some funds allocate 50 or 60 percent of their shareholders’ money to risky technology stocks in 1999 if it were not for the intense pressure to own stocks that were “going up” in an otherwise declining market? Fund holders become, in effect, unwitting speculators in a game where the largest rewards go to the fund managers whose bonuses are linked to eking out a few hundredths of a percentage point of performance versus some index, regardless of risk. Buffett’s billions provide an even more dramatic example of the divergence of practice and principle: for institutional money managers, cash balances of that magnitude are anathema in a rising stock market. Holding cash depresses relative results versus the indexes and competition—a criterion more important than principle for those who play this game.

We have often observed that when dealing with things financial, it is probably not a good idea to do what everyone else is doing. Investing’s fundamental rules tend to support this idea. Investing is based on values (so-called styles, such as “growth” or “value,” do not matter). Allocating huge amounts of investor assets to value-challenged tech stocks in 1999 made no sense from this perspective, and eventually led to a huge waste of capital, no longer available for efficient allocation to sound opportunities. Similarly, the migration of funds to bonds earlier this year (the only assets that were “going up” since 2000) will probably meet with a fate that will be quite embarrassing for latecomers. Sometimes the investor’s analysis indicates that the best course to follow is to do nothing at all (as Mr. Buffett has apparently concluded). There is nothing wrong with allowing cash to accumulate in the absence of good investment alternatives, unless, of course, one is worried about what the market indexes or the competition may do.

With investing, half the battle is won by adhering faithfully to principles and ignoring demands that are inconsistent with those principles. We are not talking rocket science here. Sticking with principles and keeping out of trouble are means of avoiding the silly mistakes that virtually force capital into unproductive channels and fritter it away, making it unavailable to take advantage of the genuine investment opportunities the markets sometimes offer the well prepared.

* For the classically challenged: Behold Speculation


Dennis Butler, MBA, CFA