Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

April 1995

A corporate executive whom we greatly admire said recently of his company's acquisition strategy: “We won't transfer value to selling shareholders in any potential transaction.” This seemed an apt statement with which to begin our discussion, as will soon become clear.

Being in the industry we are in, we are often asked such questions as “What do you think of the market?” or “Do you think such and such a stock is going to go up?” or “Where are interest rates heading?” Quite frankly we are embarrassed by such questions since our answer is, invariably, “We don't know.” Most people seem to find this response frustrating, apparently because they think that since we buy securities, we must, therefore, have an opinion on the direction that prices will take. It's just not so.

We have given some thought to the question of why people express such puzzlement over our attitude and we conclude that it is the result of a basic confusion about the kind of business we are in. We fear this confusion has such an impact on the way people approach financial services, especially investment advice, that it is worthy of some lengthy comment and clarification.

We suspect that the average person, when he or she thinks about investments, tends to see the purveyors of advice on these matters as being about the same: in other words, they all claim to be interested in providing income, growth of assets, etc. We would urge a little more discrimination because there really is more than one way to achieve these goals. When we evaluate a potential investment for our clients, we seek to determine, among other things, whether we want to be involved in the business. Do we understand it? Do we like the people? Are we comfortable with its prospects? Likewise, the consumers of investment advice need to understand the nature of the advisor's business--how does the advisor see him/herself as an investor? Answers to these questions will reveal much about the objectives of an investor's operations and help determine whether the clients will ultimately be comfortable with how the advisor handles their money.

To illustrate what we mean, we'll précis our conception of what we do and show how it helps determine what clients expect from us. We think of ourselves as being in the business of buying businesses. This way of defining our role has definite implications for our operations. We are very careful about the commitments we make, for example, and are patient in our search for appropriate acquisitions. When we do buy securities, we do so with the intention of holding them--possibly for very lengthy periods of time. Whether or not the “stock will go up” is really of little concern to us.

What is important to us is paying a reasonable price for our business investments. This is where the public stock markets, besides providing access to ownership, have a profound effect on our activities. While we claim no special ability to predict security prices on a short-term basis (in fact, we don't believe it is even worth the effort to try), underlying our work is the basic assumption that economic wealth will gradually increase over time and such increase will be reflected in the earning power of businesses, in turn increasing their values and the market prices of the publicly owned corporations. In the short term, however, market prices are volatile and can sometimes swing above or below any reasonable reflection of earning power. It is these short-term fluctuations that create situations where we can make investments in businesses without “transferring value” to others. We buy when we feel we understand the business and when convinced the price is reasonable enough to make the commitment worthwhile. Hence our awkwardness when asked about the direction of prices. We just don't know, care little and, indeed, sometimes hope for lower prices so we can increase our ownership positions.

From reading this description, it should be clear that a client can expect certain things from us, such as low turnover, lower trading costs and fewer realized gains with their associated tax liabilities than they might experience with more active stock traders. They might also look forward to seeing a “contrarian” streak in our work as we tend to be more active investors during times of uncertainty and depressed prices, as was the case during 1994. If they are accustomed to a short-term orientation, they may find us challenging to deal with since our horizon tends to be very long term.

Unfortunately, in our view, consumers of investment services are usually only familiar with the investment business as it is conducted by brokerage firms or mutual fund organizations or reported in the financial press. The impression one gets from these sources frequently bears little resemblance to the type of investment operations we have just described. Some exceptionally fine work takes place within these institutions, but all too often the outlook is very short term and securities are viewed more as commodities to be traded than certificates representing a financial interest in a real economic entity. Competition among the institutions introduces additional pressures as the need to “avoid missing a move” exacerbates short term thinking and the frenetic pace of trading. Here, in a very real sense, the objective is to buy securities whose price “will go up” and much effort is expended in attempting to determine just how high they will go and over what period of time. Whether or not a business is selling for a dear price may not even make a difference since the objective is to predict price moves regardless of current valuation. The abhorrence of transferring value is replaced by the hope that someone else will be willing to transfer even more value than you by paying a still higher price.

Some may object to our characterization of the school of investing that relies heavily on forecasting earnings and prices. After all, there are individuals and firms who adhere to this philosophy and produce excellent results. But lest our readers write off these contrasting methods as simply different ways to reach the same goal, just as one car model will get you to your destination as conveniently as another, we hasten to point out once again that each approach represents a distinct way of conducting the business. Each has different implications in terms of costs and, in our view, the level of risk taken with client funds. In this case, what can a client expect? A short-term horizon and buy/sell mentality will generally mean higher turnover--more transactions--and elevated trading costs. Taxes may be higher. Short term operators also tend to be attuned to what the market “is telling them” and their ebullience, and forecasts, tend to follow the ebbs and flows of market prices. Finally, these investors, since they make it their business to do so, are very good at making price and market predictions and are ever ready with answers to questions like “Where is the market going?” Psychologically this may be more satisfying to those inclined to worry about such matters, but we doubt whether the more tangible benefits of such talk are very lucrative. Moreover, we would argue that the most successful of the forward-looking investors combine the emphasis on future successes with a long-term perspective and caution concerning the price paid. We have a lot of respect for this approach and use its insights in our own work, even though we shy away from relying too much on optimism regarding future developments for the success of our investments.

In summary, we suggest to those seeking investment advice that they know the right questions to ask and also how to interpret the answers. Market prognostications, stock stories or commodity price predictions share the same characteristics as stock “tips”--easy to come by and not worth paying much for. Real investment work is harder and, hopefully, more fruitful over time. We suggest that potential clients find out what the nature of the investor's business is and satisfy themselves that it merits their involvement.

*                         *                         *

Although we shun making predictions of any sort regarding stocks, etc., our clients and readers know that we don't hesitate in voicing strong opinions about the level of prices and the risks associated with paying up for merchandise. They also know that our risk averse nature led us to shy away from activity for much of the last few years. We came out of our shell in 1994. We can hear the cries of Schadenfreude! now, but the loud moaning and groaning coming from Wall Street last year was music to us. It meant distressed selling and that created good opportunities during the course of the year as stocks large and small tumbled in the face of higher interest rates. In fact, some excellent businesses that usually are priced beyond our means became reasonably valued. The wailing came from shareholders who earlier had been led to believe that stocks at any price were better than CDs yielding 3%. We were more than happy to purchase shares from a few worried sellers, generously providing relief from the burdens of stock ownership and permitting them to return to the safety of money market funds and treasury securities.

*                         *                         *

While our readers have generally given very positive, if not raving reviews to our commentaries, a few--very few--have criticized our, shall we say, “negativism.” Negativism? Actually, we prefer the terms “sarcasm” and “cynicism.” We try to convey to our clients and readers something of the nature of the environment in which we work and how important it is to maintain a healthy level of skepticism and independent judgment in a world full of sales pitches and Groupthink. It is difficult for the layman to discern, let alone question, the bullish bias found everywhere in the investment community. We like to think, therefore, that our clients prefer to have a professional cynic aggressively representing their interests, as opposed to someone whose loyalties may be divided. We also would like to add that we are not always so negative. For instance, we felt practically alone in our cheerfulness in 1994. Earlier this year we made note of an article in the Wall Street Journal describing the change in sentiment on Wall Street that had helped lift stock prices. We applauded the return of high spirits to the stock trading crowd. After having dealt with their whining and selling last year, we were more than happy to see their buying this year. We welcomed this change of heart and found it to be a very “positive” development--especially for our clients.

 

Dennis Butler, MBA, CFA