The secret is out! The volatility around a flat performance in the second quarter proved that successful investing is difficult for most equity managers. While the quarter was essentially flat, individual months, weeks, and certain days showed wide up and down swings. (Future posts will deal with the mechanical/devoted capital sources for this volatility.) Even before this saw tooth pattern, a number of fund organizations and astute investors were seriously questioning their reliance on labeled strategies.
The label trap
In our work selecting mutual funds for clients, we have detected at least five sizeable fund organizations that are having deep internal discussions as to how to improve the overall performance of their family of funds. I suspect there are many others quietly going through the same exercise. Similarly, various institutional investment committees are asking related questions. A magnetic compass has the comforting aspect that it always points to magnetic north and one can then, with a high degree of certainty, triangulate to where one wants to go.
In these internal fund group discussions there is a sense that possibly they have lost the arrow pointing to magnetic north. All of the groups that are troubled by their recent performance have in the past had good absolute and relative performance, just not now. In many cases this unease has been building over the last several years. Their fundamental question is whether they should throw away the compass because after all we now live in a “GPS World.”
In the equity world, the compasses that worked well in the past were various labels; e.g., growth, value, growth at a reasonable price (GARP), quality, income, etc. I believe that these supposedly distinctive labels have been proven to be traps for investors and managers. Traps because they did not provide winning results. The dispersion of performance results of portfolios gathered under these labels has been much too wide to be useful. Bad performers on an absolute basis can be found under each label and the top performer rosters include funds that march under different labels.
The need for labels and abbreviations
We live in an abbreviated or sound bite society. Because so much is happening in the various worlds around us, we feel compelled to gather an ever increasing bundle of information. In order for us to store all of the elements of information we need to file in our mind (or on our computer, smart phone, etc.) distinct categories are needed to help us in recovering the relevant information when we need it. Even in our enormously underutilized brains (both physical and digital) there are capacity limits. To be able to cram more information into these spaces we abbreviate the addresses for each element of storage.
I used the expression “GPS World” above. All of the travelers out there know what GPS is and what it does. Many may not immediately recall that GPS stands for global positioning system. Fewer will remember that it is based on signals from satellites in the sky. These satellites were put in place initially to help our space probes. (Much of this pioneering effort was conducted at the Jet Propulsion Laboratory of Caltech where I am lucky enough to be a trustee and sit on their investment and other committees.)
Notice how the combination of labeling and abbreviated addresses has replaced relying on magnetic north to guide us. I wonder whether we have adjusted our philosophy due to this switch. This change is very similar to the quandary facing many investment organizations and investors today.
Labels are investment commands
As we grew up our parents and other authority figures reinforced their observations and directions by the label “good boy” or “good girl.” Years later we hardly remember what the original issue was, but we do remember the label of being good.
Often our first serious investing class is taught by an academic, with or without a CFA. In an enlightening period of roughly fifty minutes the instructor wants to present an investment concept often with complex graphics and tables. The clear message is that if one follows the concept, “good” things will happen. Perhaps the professor briefly discusses the data, rarely pointing out the holes in the data or periods when the concept did not work. Unfortunately, these courses are not taught from the vantage point of handicapping horses at a race track. Horse racing data always has holes in it because most histories are quite short and conditions of the track, the race, and the nature of the competitors change. From a gambler’s (or if you prefer, an investor’s) standpoint, the odds or perceptions in the marketplace are a measure of the reliability/ predictability of the data. For a numbers junkie like me, the data does not show the direct impact of personalities of the jockey, trainer, owner, groom, and racing officials. Thus, the appellation that a horse is a sprinter, or comes from behind, has beaten worse horses, or similar moving up in quality labels should be taken in with skepticism. The terms “growth,” “value,” and “good quality” should be received with some doubt, as periodically they are not predictive of investment results.
While the academics and other pundits are the initial broadcasters of these labels, investment sales people are major users of labels as they have an even a shorter period of time to convince an investment committee or an individual investor the wisdom (predictability) of a concept. If in the first five minutes of the encounter positive interest and possible excitement is not raised, the odds are that it will be a tough sale. The marketing force behind the salesperson is also a heavy user of recognizable labels as it tries to find the right existing products to fit its perception of the quick reaction marketplace. Within many investment organizations the political power structure is driven by sales and marketing people and the labels that they have been taught.
New labels are needed
Coming out of the Great Depression of the 1930s most investors were focused on preservation of their equity capital with heavy emphasis on price-to-balance sheet factors. These concepts were generated by Benjamin Graham in his portfolios and taught by him and Professor David Dodd at Columbia University. Professor David Dodd then taught me. They were the authors of the seminal book, “Security Analysis” which many investors (including CFA candidates) use as their Bible.
Their focus was what on the assets could be turned into cash quickly. They did not value inventories highly and paid no attention to intellectual property or franchise value. Nevertheless, these precepts are often the basis of so-called value investing today. A few years later, but still in the 1930s, an investment counselor in Baltimore, among a few others, favored investing in the stocks of companies that were regularly growing their earnings. Thus, Mr. T. Rowe Price was one of the very first investors to invest for growth. Well into the 1950s and early 1960s growth was not a popular label for stock portfolios.
In recognition of the needs to come up with new investment strategies, Investment & Pension Europe in June published a special report on Risk and Portfolio Construction which showed that in Europe, investment people are looking to find better ways to construct successful portfolios. As with US based consultants, they have noted that there has been “style drift” in portfolios. Instead of treating this as a violation of a mandate, I would suggest that either market conditions or specific security conditions changed or the manager is groping his/her way to a perceived better investment dictum. Another factor, (discussed in last week’s post) are the impacts of flows. In the short-term, large in or outflows can dramatically change the performance characteristics of a portfolio’s performance which to the untrained eye might be seen as a violation of some label.
New labels on the horizon
Goldman Sachs has also recognized the problems with the existing popular labels. In their analysis of the performance of the S&P500 they have introduced a large number of filters. My favorites from their long list are:
- EBITDA growth
- Sales Growth
- Enterprise Value to EBITDA
- Enterprise Value to Free cash flow
- Profit margins
- Return on equity
- International Sales (also by region)
- Tax rate
- Balance Sheet strength.
I would add a few others:
- Franchise value
- Replacement value
- Ability to successfully disrupt
- Major changes in management attitude and capability
- Institutional ownership
- Media sensitivity.
Since I am not confident that I can predict the future with any degree of certainty, like a good general I want to learn quickly what killed my troops (investment positions) and avoid those types of losses in the future. One of the lessons undoubtedly will be not to put too much emphasis on labels. For those beneficiaries that I have responsibility toward, I hope to make new mistakes not to hold labeled errors.
Which investment label do you feel is most dangerous?