“If you attack stupidity you attack an entrenched interest with friends in government and every walk of public life, and you will make small progress against it.”
Samuel Marchbanks
Those of us who were value investors and running money back at the beginning of 2000, remember what a horrible time it was. For some years value had been lagging growth in performance. We were routinely told, either in emails or other communications from our investors, that our style of investing was never coming back, that we were dinosaurs who hadn’t recognized that we were extinct, and that technology stocks were the place to be as they represented the new economy. Then we got to March of 2000.
From March of 2000 through October of 2002, the NASDAQ Composite lost 78% of its value. Looking back afterwards, it was easy to see the signs of excess which had been cavalierly ignored. In 1999 there were 457 initial public offerings of new companies, and 117 of those doubled on the first day of trading.
By 2001, the number of initial public offerings had shrunk to 76, and none of those doubled on their first day of trading. It became increasingly clear that many of the companies that had raised capital consisted of little but a back of the envelope idea, and no business plan. In many respects, those companies were nothing more than bold grabs of capital from those only too willing to roll the dice in hopes of catching the next Microsoft. The result was the destruction of billions of dollars of investment capital. Concurrently, there was a setback to the willingness of venture capitalists to invest in new technology ideas that would come from either Silicon Valley or the Boston Route 128 Beltway.
Fast forward to July of 2018, and what do we find? Well, again value is lagging growth stock investing.
And this time it is different, because the companies that have been driving the markets, the so-called FAANG (Facebook, Amazon, Apple, Netflix, Google) stocks, are real businesses. And we would never be fooled into thinking that the growth rates of these companies are not sustainable. And then July 25, 2018 happened. Facebook announced slowing growth numbers and missed its earnings estimates. Approximately $120B of investor capital was wiped out as the stock fell more than 19%, in the largest one-day loss for a company ever, on the U.S. exchanges.
That this sort of tumble was coming should not have been unexpected. In recent months, more and more value investors were choosing job or franchise security over any sense of responsibility to their investors and throwing in the towel to purchase in the so-called FAANG group or in other areas of technology. The rationale was that this time, these real businesses had strong balance sheets, and real earnings. And if the valuations were at extremes? If GAAP accounting did not properly represent the correct valuation multiples for these asset-light (not requiring a lot of money going into capital expenditures to replace or maintain plant and equipment) businesses? Well, another methodology would. And on we moved to new highs on the indices, but with a clearly very narrow breadth.
Which is where we sit now. One suspects that we are engaged in one of those games of musical chairs that regularly takes hold of the markets. Participants try and figure out how long they can continue to hold on to an investment when the valuation is in never-never land. On the one hand, selling too soon may be a threat to job security. And on the other hand, not selling may also be a threat to job security. And to compound the problem, never owning the FAANG stocks may also be a threat to job security. No matter of course, if it is other people’s money that we are talking about.
A portfolio manager friend who used to run a small cap value fund for Taft Hartley money in Chicago before she fled to the warmer climate of Texas was recently updating me on money management firms in Chicago. Many have been seeing assets running out the door for all the usual reasons – performance, style, etc. Some of the smaller ones, lacking scale and diversity in their product offerings, have been closing their doors. And while the move into passive funds seems to have slowed, there has not been a wholesale reversion to active managers. Overall, the investment community seems to be in a state of flux. This coincides with what I have been hearing from other parts of the country.
Amongst the larger firms, it has been business as usual, but for the fact that stylistic differences notwithstanding, there is a tremendous amount of overlap of security ownership in both growth and value portfolios. That coupled, with the large amounts of moneys that have gone into S&P 500 index products means that any shift to sustained selling will result in a tsunami to the downside. We recommend again, as we have before, that investors reassess their risk tolerances and time horizons. If one is looking at college tuition bills or retirement within the next twelve to eighteen months, now is not the time to enter into a game of “silly buggers” with the markets.
Which brings us to the age-old question of “Who will watch the watchmen?” Some thirty years ago, the professions such as law, medicine, and yes, investment counseling, were filled with Renaissance men and women, generally with strong liberal arts educations undertaken before their specialty training in law, medical, or business school. They had interests and hobbies, priding themselves on being familiar with subjects outside of their business areas. This tendency had come over from Great Britain, where the concept of the gifted amateur existed then and continues to exist today. It was not unusual to find for instance an attorney who collected art, might know as much about Qing Dynasty landscapes as a full-time museum curator or art dealer.
Sadly we have moved away from that model, exemplified by the average hedge fund or private equity manager, best categorized as “barbarian with money” who is now led around by the new Mandarin class of “consultants.” Hence we have those who label themselves as collectors, whose collections are replete with items purchased, not because the individual liked the art, but rather because in ark-like fashion a “consultant” had suggested that he or she must have one of the specified items, which would of course double or triple in value in a very short time.
We now see the same thing in the investment world, where the clients, especially endowments, now hire consultants to tell them how to allocate their investments to outperform some artificially constructed benchmark. The problem comes when the advice of the consultant is used to avoid taking ownership of the decision-making process. Common sense gets checked at the door. Part of the problem is the American tendency to try and reduce everything to a science rather than recognize that sometimes an art is involved, even if it is relegated to the selection and application of the right mental models. Sometimes however we get lazy about the process. And that leads to an effort to avoid taking responsibility for the decisions made, because not everything can be reduced to a decision tree.
The same thing applies to individuals. At the end of the day, what the broker or financial professional recommends to you is just that, a recommendation. You, as the client, need to participate in the process, and recognize that you need to take ownership of the decisions made. And you need to make sure you are not fooling yourself about your own risk tolerances and patience.
