Speculate on your investment. Not your broker.
Brokers will say the darndest things to get your business, as this advertising slogan coined by a member of the discount variety of that profession so readily attests. But what does it mean? Hopefully only “reflection” is implied, but that is far from clear. Since Wall Street is fond of its adages (“Buy low, sell high”, “Buy the rumor, sell the news”, etc.), perhaps the firm believes it is contributing to a rich tradition of investment lore. Or, it may be suggesting that investment somehow entails speculation. Would it go another step and make no distinction at all between the two, thereby revealing a long and closely held secret on Wall Street -- that much of what the Street would call investing is really little more than wagering?
Our regular readers will immediately recognize the radical confusion evidenced in the phrase “speculate on your investment” and have no trouble seeing such slogans for what they are, namely, nonsense. For others it is sometimes not so easy. As the thunder continues to roll in from the Federal Reserve's lightening strikes earlier this year, some market participants are learning to their dismay that not only were they speculating on their brokers, they were gambling with what they thought were their investments. During the last week of September the SEC announced that for the first time ever a money market fund had liquidated and returned to investors only 94 cents on the dollar (It had “broken the buck.”). Interestingly enough, the name of the fund was Community Bankers US Government Money Market Fund. Also interesting was the fact that 40% of the fund's assets were held in “structured notes”, a type of security whose return to the investor is determined by the performance of some kind of index: in other words, derivatives, not plain vanilla, super safe federal government obligations, as the fund's name would seem to indicate.
Community Bankers marketed its small fund solely to institutional investors, so a few of those big boys and girls, who presumably are paid to know better, had to eat the losses. Not so a fiasco brought to the public's attention in August when front-page stories described how the manager of another supposedly conservative “short term bond fund”, known as the Institutional Government Income Portfolio, lost $700-800 million using other people's money to place big bets on “unseasoned” and “exotic” securities. This time individuals and the heads of charitable organizations, municipal orchestras and other groups not usually known for being wild-eyed market plungers found themselves, ironically, uttering the speculator's prayer: “Oh Lord, make me even and I promise I'll never, ever do it again!”
Both of these examples illustrate the problems that can occur when money managers acting in a competitive environment too often turn away from the tried and true and towards the theoretical and untested in hopes of getting the edge. This behavior is especially egregious during strong markets when the positive financial atmosphere makes it seem as if every innovation works (and every innovator is a genius) and when risks either are not apparent or are overlooked or ignored. Indeed, we spent much of last year warning our investors about the dangers inherent in the ebullient spirits, complacency and easy optimism that accompany high and rising security prices. This year, as we have just seen, some of the chickens have come home to roost as a result of the Fed's new policies. The attitude in the marketplace is now one of “caution”, if not downright gloom.
This change in environment is not entirely evident at first glance. Earlier this year we described how the market declines experienced in February and March did not really amount to much. Year-to-date the averages still exhibit little damage. The S&P 500 index, for example, was actually up 1.3% for the nine months ending September 30, after a relatively strong third quarter. But the fears which have beset the markets this year have caused a great deal of grinding turmoil whose impact, though not reflected in the average figures, is found in thousands of individual issues. The prices of the majority of stocks actually peaked in January and now about 70% are 20% or more below their high prices for 1994. 40% are down more than 30%. Broad groups of securities have suffered. Utility stocks, for example, began a decline in October, 1993 that has shrunken their market value about 30% on average during the past year. Brokerage and other financial concerns, homebuilders and energy companies have also experienced steep price declines. Some truly unique and wonderful businesses have seen their shares drop significantly, although not enough to warrant our purchasing them as yet.
We do not mean to imply that security prices now represent the compelling values that they did in previous periods such as 1974, 1982 or 1990. On the contrary, there remains considerable market risk as average valuations are still quite extended and accelerating inflation or higher interest rates could hurt paper assets across the board. Our job, however, is not to speculate on these broad questions, but to find individual businesses selling at prices suitable for long term investment. As for our investment operations, 1994 has seen us take a more active stance as high expectations have been deflated and stocks have in some cases fallen to more reasonable levels. This is in stark contrast to 1993 when we found little to interest us. In fact, these are the most interesting times in 2-3 years as more and more potential opportunities for investment come into view. As investors we can prepare for future bull markets by carefully putting funds to work now at lower prices and with correspondingly lower risk.
We should conclude our remarks with some observations on October, a month that chills the hearts of even the most optimistic of market operators. On the 19th we commemorate the 7th anniversary of the Crash of 1987, one of the great financial follies of recent times and a defining moment for the many newcomers to Wall Street in the 1980s (By the way, the folly was not that prices fell 22% in one day, but that they rose 35% in the first 9 months of that year.). We vividly remember the day of the Crash. We were puzzled as a highly regarded, oft-quoted “value” investing guru stood by as if paralyzed while the market values of many great companies just melted away. Equally remarkable was the crowd later that evening at Harry's of Hanover, a favorite watering hole for stock trader types near Wall Street in lower Manhattan. Without exception everyone we talked to had sold out soon before the debacle. Presumably only winners needed a drink after such an event.
Anecdotes aside, the great lesson of the Crash of 1987 -- not to get caught up in the emotions of the marketplace, positive or negative -- seems especially valuable today after having passed through yet another spate of euphoria followed this time by an extended period of hand-wringing. As always, we maintain that a detached, independent and long-term perspective is necessary in these matters in order to achieve good results at an understandable level of risk and reasonable cost.
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Just now we spoke of the impact which competition has on the business of managing other people's money, an issue we have discussed at length in previous letters. Clients, who, unfortunately, sometimes view the whole business as they would a horse race, often pay the price for mistakes made as one manager seeks to outmaneuver another to gain a short-term advantage. The enclosed article detailing recent problems facing some fund managers makes clear the potential hazards of misplaced competitive urges.
Dennis Butler, MBA, CFA