We’ve Seen This Movie Before

By Edward A. Studzinski

By Edward Studzinski

“We do not have to visit a madhouse to find disordered minds; our planet is the mental institution of the universe.”          Goethe

For students of the stock market, one of the better reads is John Brooks’, The Go-Go Years.   It did a wonderful job of describing the rather manic era of the 60’s and 70’s (pre-1973). One of the arguments made then was that the older generation of money managers was out of touch with both technology and new investment ideas. This resulted in a youth movement on Wall Street, especially in the investment management firms. You needed to have a “kid” as a portfolio manager, which was taken to its logical conclusion in a cartoon which showed an approximately ten-year old sitting behind a desk, looking at a Quotron machine. Around 2000, a similar youth movement came along during the dot.com craze, where once again investment managers, especially value managers, were told that their era was over, that they didn’t understand the new way and new wave of investing. Each of those two eras ended badly for those who had entrusted their assets to what was in vogue at the time.

In 2008, we had a period of over-valuation in the markets that was pretty clear in terms of equities. We also had what appears in retrospect to have been the deliberate misrepresentation and marketing of certain categories of fixed income investments to those who should have known better and did not. This resulted in a market meltdown that caused substantial drawdowns in value for many equity mutual funds, in a range of forty to sixty per cent, causing many small investors to panic and suffer a permanent loss of capital which many of them could not afford nor replace. The argument of many fund managers who had invested in their own funds (and as David has often written about, many do not), was that they too had skin in the game, and suffered the losses alongside of their investors.

Let’s run some simple math. Assume a fund management firm that at 2/27/2015 has $100 billion in assets under management. Assets are equities, a mix of international and domestic, the international with fees and expenses of 1.30% and the domestic with fees and expenses of 0.90%. Let’s assume a 50/50 international/domestic split of assets, so $50 billion at 0.90% and $50 billion at 1.30%. This results in $1.1billion in fees and expenses to the management company. Assuming $300 million goes in expenses to non-investment personnel, overhead, and the other expenses that you read about in the prospectus, you could have $800 million to be divided amongst the equity owners of the management firm. In a world of Marxian simplicity, each partner is getting $40 million dollars a year. But, things are often not simple if we take the PIMCO example. Allianz as owners of the firm, having funded through their acquisitions the buy-out of the founders, may take 50% of profits or revenues off the top. So, each equal-weighted equity owner may only be getting paid $20 million a year. Assets under management may go down with the market sell-off so that fees going forward go down. But it should be obvious that average mutual fund investors are not at parity with the fund managers in risk exposure or tolerance.

Why am I beating this horse into the ground again? U.S. economic growth for the final quarter was revised down from the first reported estimate of 2.6% to 2.2%. More than 440 of the companies in the S&P 500 index had reported Q4 numbers by the end of last week showed revenue growth of 1.5% versus 4.1% in the previous quarter. Earnings increased at an annual rate that had slowed to 5.9% from 10.4% in the previous quarter. Earnings downgrades have become more frequent. 

Why then has the market been rising – faith in the Federal Reserve’s QE policy of bond repurchases (now ended) and their policy of keeping rates low. Things on the economic front are not as good as we are being told. But my real concern is that we have become detached from thinking about the value of individual investments, the margin of safety or lack thereof, and our respective time horizons and risk tolerances. And I will not go into at this time, how much deflation and slowing economies are of concern in the rest of the world.

If your investment pool represents the accumulation of your life’s work and retirement savings, your focus should be not on how much you can make but rather how much you can afford to lose.

Look at the energy sector, where the price of oil has come down more than 50% since the 2014 high. Each time we see a movement in the price of oil, as well as in the futures, we see swings in the equity prices of energy companies. Should the valuations of those companies be moving in sync with energy prices, and are the balance sheets of each of those companies equal? No, what you are seeing is the algorithmic trading programs kicking in, with large institutional investors and hedge funds trying to grind out profits from the increased volatility. Most of the readers of this publication are not playing the same game. Indeed they are unable to play that game. 

So I say again, focus upon your time horizons and risk tolerance. If your investment pool represents the accumulation of your life’s work and retirement savings, your focus should be not on how much you can make but rather how much you can afford to lose. As the U.S. equity market has continued to hit one record high after another,  recognize that it is getting close to trading at nearly thirty times long-term, inflation-adjusted earnings. In 2014, the S&P 500 did not fall for more than three consecutive days.

We are in la-la land, and there is little margin for error in most investment opportunities. On January 15, 2015, when the Swiss National Bank eliminated its currency’s Euro-peg, the value of that currency moved 30% in minutes, wiping out many currency traders in what were thought to be low-risk arbitrage-like investments. 

What should this mean for readers of this publication? We at MFO have been looking for absolute value investors. I can tell you that they are in short supply. Charlie Munger had some good advice recently, which others have quoted and I will paraphrase. Focus on doing the easy things. Investment decisions or choices that are complex, and by that I mean things that include shorting stocks, futures, and the like – leave that to others. One of the more brilliant value investors and a contemporary of Benjamin Graham, Irving Kahn, passed away last week. He did very well with 50% of his assets in cash and 50% of his assets in equities. For most of us, the cash serves as a buffer and as a reserve for when the real, once in a lifetime, opportunities arise. I will close now, as is my wont, with a quote from a book, The Last Supper, by one of the great, under-appreciated American authors, Charles McCarry. “Do you know what makes a man a genius? The ability to see the obvious. Practically nobody can do that.”


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About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. He was a partner at Harris Associates in Chicago, Illinois. Harris is known for its value-oriented, bottom-up investment approach that frames the investment process as owning a piece of the business relative to the business value of the whole, ideally forever. At Harris, Ed was co-manager of the Oakmark Equity & Income Fund (OAKBX). During the nearly twelve years that he was in that role, the fund in 2006 won the Lipper Award in the balanced category for "Best Fund Over Five Years." Additionally, in 2011 the fund won the Lipper Award in the mixed-asset allocation moderate funds category as "Best Fund Over Ten Years. Concurrently Ed was also an equity research analyst, providing many of the ideas that contributed to the fund’s success. He has specialist knowledge in the defense, property-casualty insurance, and real estate industries, having followed and owned companies as diverse as Catellus Development, General Dynamics, Legacy Hotels, L-3, PartnerRe, Progressive Insurance, Renaissance Reinsurance, Rockwell Collins, SAFECO, St. Joe Corporation, Teledyne, and Textron. Before joining Harris Associates, over a period of more than 10 years, Ed was the Chief Investment Officer at the Mercantile National Bank of Indiana, and also served on their Executive and Asset-Liability Committees. Prior to Mercantile, Ed practiced law. A native of Peabody, Massachusetts, he received his A.B. in history (magna cum laude) from Boston College, where he was a Scholar of the College. He has a J.D. from Duke University and an M.B.A. in marketing and finance, as well as a Professional Accounting Program Certificate, from Northwestern University. Ed has earned the Chartered Financial Analyst credential. Ed belongs to the Investment Analyst Societies of Boston, Chicago, and New York City. He is admitted to the Bar in the District of Columbia, Illinois, and North Carolina.