Short-term Gratification and Long-term Return
Tocqueville Asset Management
By François Sicart
September 21, 2012
Over time, I have tried to learn from my investment experiences. As a result, my style has become influenced less by greed and fear and more by patience and realism. Here are a few of the lessons I have learned and passed along.
In my observation, more capital is lost or wasted as a result of poor life choices than because of inadequate investment performance. I believe that this occurs because money is often given symbolic or even magical attributes that do not lead to rational patrimonial decisions.
To some investors, capital acts as a financial Viagra, the effects of which eventually dissipate when reality reasserts itself. Other investors dream that investing success will magically allow them to afford a lifestyle that they rationally cannot sustain. Still others, usually with inherited money, treat their capital as a magical fountain of wealth that cannot be replicated, and they thus live in constant fear of its loss or confiscation through taxes or other means.
Patrimonies are real money. But money needs to be demystified.
In planning for family patrimonies, I strive to help clients treat money seriously but, at the same time, to demystify it and accept it for what it is: a wonderful tool. This, like all taboo-fighting endeavors, is a process. But even people who already possess a healthy attitude towards money have some legitimate reasons for anxiety.
For example, a young client recently asked me, “Not being familiar with investments, how, when choosing an advisor, do I stay away from the Madoffs, Sanfords, and other Ponzi artists of the world?”
Two answers immediately come to mind.
First, as we have all heard (but don’t always follow), if a scheme seems too good to be true, it probably is not true. Faced with intimidating “experts” we are sometimes tempted to underestimate our own intelligence. But common sense dictates that without some risk there is no reward potential. It thus follows that it is safer to pass over any investment opportunity presented as riskless.
Whether a potential investor is dealing with Madoff and his purported black box, Enron when it was high-flying, or the Nobel Prize-studded but over-leveraged Long-Term Capital Management, “I don’t understand” usually is a perfectly legitimate reason to pass over an investment opportunity.
Most importantly, one should remember that risk and volatility are not the same. Risk is the possibility of permanently losing capital. Volatility, on the other hand, is the manifestation of highly cyclical crowd psychology. Obviously, excess risk should be avoided; but I do not believe that avoiding portfolio volatility is a viable strategy. On the contrary, emotion-driven ups and downs should be viewed as temporary divergences from reality and thus sources of opportunity.
Second, in structuring patrimonies, I have always insisted – even when I personally have broad powers on behalf of clients – that all the responsibilities should not be in the same place. Some may argue that, as a portfolio manager myself, I have an axe to grind when I do not advise hiring multiple portfolio managers to achieve this goal. But I believe that the necessary separation of powers lies somewhere else. An independent custodian should be allowed to send money only to authorized recipients; a portfolio manager should be allowed only to give orders to buy and sell securities, but not to send money out of the account; a trustee, who theoretically has very broad powers, usually can only implement them by going through the custodian and/or the portfolio manager. If the latter two feel a responsibility to the beneficiaries, this should at the very least raise alarm bells in case of “unusual” directives received from the trustee.
Patience and discipline build up a boring fortune.
Beyond patrimonial planning, when dealing with portfolio monitoring, I try to help clients define realistic expectations and convince them to trust common sense over intellectual capabilities or mathematics.
For that purpose, I often refer to the long-term record of the sample account I first introduced on June 25, 2007 (see “The Rear Long View”). The table appended to this article has been updated through 2011 and should not be viewed as the promise of future performance. I use it principally to illustrate that investment performance is less a function of bright ideas than of sticking with a chosen discipline.
In brief, I have managed or co-managed this account since the end of 1974, first with my partner Christian Humann at Tucker Anthony; then alone; and, since 1992, with the help of my partners at Tocqueville Asset Management. I chose it in part because it is the only account for which we have more than 30 years of audited records; in part because it, together with a few others that we have historically managed without outside constraints or disruptions, constitutes a material portion of the assets under our management; and finally because I believe this account’s performance is fairly representative of the contrarian/value approach I have chronicled over the years.
The first observation that jumps out of the table is that, after fees, the account has outperformed the S&P 500 by an average of 1 percent per annum over 36 years. Although the majority of investors reportedly fail even to match the performance of that index over significant periods, a 1-percent advantage hardly seems the mark of genius. However, if you assume that the client started with $1 million, this small annual difference would mean that his or her portfolio is worth nearly $75 million today instead of less than $54 million. Rather than genius, that is the combined magic of patience and compound interest.
NB: I should point out that long-term performances in the 11- to 12-percent-per-year range are not typical of history and were boosted, in this case, by very depressed stock market valuations at the start of the measuring period, in 1974.
From misunderstandings to investment success.
An inescapable rule of investing is that even the best among us will make mistakes. Since I speak of “the best among us,” I will leave aside mistakes due to emotions or “the madness of crowds.” But the remaining options are many. Some mistakes are small, frequent, and par for the course, such as the inability to buy at the exact low or to sell at the exact high. Others may result from severe market reactions to so-called “black swans” – rare and momentous events that are almost impossible to anticipate, at least with any accuracy. There also are some mistakes we should be able to avoid, though we sometimes don’t. In particular, it is easy to misunderstand the real drivers and vulnerabilities of the businesses in which we invest.
I vividly remember a 1970s dinner with Don Davis, then CEO of Stanley Works. This company, although increasingly successful and global, had purposely retained the image of a conservative and slightly boring New England hand-tool manufacturer (at the time, they did not even make electric tools). At the end of dinner, Davis explained: “People think we are successful because we make good screwdrivers, measuring tapes, and hammers. Of course, we do. But there are many other, smaller firms that make tools that are just as good and yet are barely profitable or not at all. What we do very well is secure shelf space at major retailers, through a combination of excellent service and ample advertising closely targeted to our do-it-yourself clientele. This means we can acquire cheaply a barely profitable manufacturer of good-quality tools and make it very profitable within one year.”
No new tangible information was provided. But this new understanding of Stanley’s real business reinforced our conviction in the company, and we remained shareholders for a number of years.
The irony of this story is that, at the time, it was Black & Decker that was the glamour stock in the do-it-yourself business. It constantly introduced new electrical products and new designs, and its management had gained a reputation for being marketing geniuses. To reflect Wall Street’s comparative enthusiasm for the two companies, in 1972, at the peak of the “Nifty-Fifty” market, Black & Decker’s stock sold at 50 times earnings while Stanley Works “languished” at 15 times earnings. Over the following 30 years, both companies had to weather economic vagaries. But in 2010 it was Stanley Works that acquired a debt-heavy and somewhat disoriented Black & Decker.
Of course, misunderstanding a company’s real business can also turn out well. One of my early clients had bought shares of Polaroid in the 1950s because he loved their polarized sunglasses. Little did he expect eventually to make a small fortune on the inventor of instant photography!
In another example, in the early 1980s, I was having a drink in Paris with Tom Schanck, then CEO of Signode Corporation. Signode was a textbook example of a well-managed U.S. manufacturing company. They made sophisticated strapping machines for packaging and shipping bulky products. The machines were profitable, but the strapping-plastic even more so: a classic example of a razor-and-razor-blades business. Tom casually asked me if I knew another Chicago company that he thought well of – Illinois Tool Works. I answered that yes, I did, but the stock always seemed a bit overvalued, in addition to which I did not really understand what they did. Schanck retorted, “It’s very simple: They go around asking manufacturers like us what kind of component or machine would make our lives easier or more productive, and then they go design and produce it.”
That simple answer allowed me to surmount my price reservations concerning Illinois Tool Works, and we made fairly decent money on the stock in the early 1980s. But, as described further down, not as much money as if we had held the stock for another 20 years. (Historical note: Signode was acquired by Illinois Tool Works in 1986.)
Understanding a company’s “real” business is key to both seeing value where others don’t and sometimes avoiding costly mistakes. I wish I had understood early that Amazon, for example, was not simply a mass bookseller, but potentially a whole new model of retailing and distribution logistics. There are innumerable other examples of companies that I initially misunderstood or underappreciated; and to this day I must admit to being puzzled by the continuous success of Nike or Starbucks, for example, both of which I initially mistook for temporary fads!
Dancing without the stars.
What is most intriguing about the Nike and Starbucks decisions, however, is that they have not mattered as much as one might have thought. As I reflected back on the performance of the last 37 years illustrated in appendix, a stunning revelation came upon me: It was achieved without owning any of the most spectacular stock-market winners of the period. To my recollection, I did not own Wal-Mart, Coke, Disney, MacDonald’s, Starbucks, Nike, Dell, Microsoft, Cisco, or even Apple – at least during their fastest-growth years.
This is a striking reminder that good companies do not always, or even often, equate with good stocks. As Warren Buffett put it, “Price is what you pay. Value is what you get.” And his teacher, Ben Graham, had explained why: “In the short run the market is a voting machine. In the long run it's a weighing machine." What this means is that there is relatively little money to be made in the short and medium term on the stock of a company that everybody recognizes as a great company. Much of that enthusiasm already is, as they say, “in the price.”
Without trying to complicate the subject, this points to a nagging contradiction in the value-investing approach. Value investors tend to view themselves as long-term holders of investment positions, akin to the owners of a business. But since the market, driven by crowd emotions and fads, tends to be bipolar, it will cyclically go from pricing a stock well below its true value to pricing it substantially above. The value investor naturally will buy the stock below its value; but, to be true to the discipline, he or she should sell it as soon as it becomes overvalued. Yet…
In researching this paper I came across one of our long-standing accounts where, for estate planning and tax reasons, some stocks were never sold that were sold years ago in other accounts. For example, the account still owns Illinois Tool Works, bought in 1980 for $2.37 and now selling for $57; and Stanley Works, now Stanley Black & Decker, bought in 1982 for $4.92 and now selling for $73. Not to mention Union Pacific, bought in 1967 (before my arrival on Wall Street) by my former boss and partner for $1.88 and now selling for $114!
In the long run, the market is a weighing machine, indeed.
Don’t be a fashion victim.
Periodically, investors become hypnotized with some indicator that they have come to believe is the single best predictor of the economy or the stock market. Very often, the indicator just is not that reliable, and sometimes it simply stretches one’s credulity.
One of the most laughable such instances is exposed by David Leinweber, director of the Center for Innovative Financial Technology at the Lawrence Berkeley National Laboratory, in his book Nerds on Wall Street (Wiley, 2009). A study of United Nations’ statistics totally unrelated to the U.S. stock market between 1983 and 1993 showed an almost perfect correlation (99 percent) between the S&P 500 index of U.S. stocks and butter production in Bangladesh, combined with sprinklings of the sheep population in Bangladesh and cheese production in the United States. Of course, the correlation stops working outside of the reference period, but Leinweber assures us that, by adding one or two irrelevant series to the model, we could restore the 99-percent correlation.
Be this as it may, what was intended as a joke triggered considerable interest among the public; and for years after the study’s publication, finance students, brokers, and journalists kept calling for updates of the model’s component statistics and results. Presumably you read some recommendations or articles overtly or covertly influenced by that correlation.
Other fads, often well documented and more credible, have periodically captured the psyche of the investment community – for example, the growth-stocks-at-any-price folly of the early 1970s.
I am concluding with this subject because I have recently detected a new paradigm driving the global stock markets, which could in time become dangerous. It is the notion that bad economic news is good stock market news.
The seed for that conviction was the “Greenspan Put,” which described a policy adopted by former Fed Chairman Alan Greenspan to inject new liquidity in the economy each time the market declined more than marginally. Now the Greenspan Put has become a “Global Central Bankers’ Put,” as the most important central banks, from Europe to China, seem to have made similar commitments.
The post-crisis global economy has provided a plethora of bad economic news, and thus, the stock markets have recovered spectacularly since the spring of 2009 – the U.S. S&P 500, for example, has just about doubled.
My problem with this new consensus is that it might make sense precisely if it were not the consensus but a contrarian position. Once it becomes the consensus, as I have mentioned before, it is “in the price,” and the market becomes vulnerable to any deviation from the expected scenario.
One thing that might go wrong, for example, is that economic developments become much worse, for longer than anticipated, and that valuation concerns might then begin to override pure liquidity considerations. This would especially be the case if still-high profit margins narrow and profits decline.
The opposite scenario might also have negative consequences for the stock market. By and large, the “real” economy competes with the financial markets for the available liquidity provided by central banks and their banking systems. When the economy is weak, so is the demand for credit. As a result, the new liquidity injected by central banks into their banking systems flows into the financial markets, boosting bonds and stocks. But when the economy and the demand for credit improve, less liquidity will normally be available for the financial markets. Interest rates should rise and stock market valuations shrink. This will be aggravated, of course, if central banks have become more complacent about economic activity and more concerned about rising inflation, which would lead them to withdraw liquidity from the economy.
Altogether, after three years of investor whining about the post-crisis economy, I find that they have become much more complacent about the economic outlook (or at least about central banks’ ability to have control over it) now that major stock markets (except China’s) have recovered strongly.
In my view, this is a good time for skepticism.
François Sicart (in New York & Mexico)
September 20, 2012
DISCLOSURE: This article reflects the views of the author as of the date or dates cited and may change at any time. The information should not be construed as investment advice. No representation is made concerning the accuracy of cited data, nor is there any guarantee that any projection, forecast, or opinion will be realized.
References to stocks, securities, or investments in this writing should not be considered recommendations to buy or sell. Past performance is not a guide to future performance. Securities that are referenced may be held in portfolios managed by Tocqueville or by principals, employees, and associates of Tocqueville, and such references should not be deemed as an understanding of any future position, buying or selling, that may be taken by Tocqueville. A list of all recommendations made for this account in the one year period immediately preceding the date of the article is available upon request. Any reference to past performance is not necessarily a guide to the future. It should not be assumed that future recommendations will be profitable or will equal the performance of the securities discussed.
We will periodically reprint charts or quote extensively from articles published by other sources. When we do, we will provide appropriate source information. The quotes and material that we reproduce are selected because, in our view, they provide an interesting, provocative, or enlightening perspective on current events. Their reproduction in no way implies that we endorse any part of the material or investment recommendations published on those sites.
|Shaded = Periods of Outperformance
DISCLOSURE:The returns discussed in this article are based upon the annual returns for each of the last 37 years for fully discretionary accounts managed by Tocqueville Asset Management and François Sicart, founder and chairman, for its largest client. The client accounts predate the formation of Tocqueville on January 1, 1990, and were managed by Mr. Sicart initially as an executive of Tucker Anthony, R.L. Day, Inc., beginning in 1974 through the formation of Tocqueville. Other accounts were managed by Mr. Sicart during the same period, and may have had different investment objectives and achieved different results. A new account with similar investment objectives and style may not achieve similar results.
Performance data quoted represent past performance and do not guarantee future results. The returns were calculated using a time-weighted monthly rate of return formula, and are presented net of advisory fees, commissions, and trading expenses, and assumes reinvestment of capital gains and dividends. The accounts are valued monthly, and transactions are recorded on a trade-date basis. Dividend income is recorded on a cash basis. Cumulative rates of return for multi-year periods are calculated by linking the annual rates with such periods. The annualized rate of return is equivalent to the annual rate of return, which, if earned in each year of the indicated multi-year period, would produce the actual cumulative rate of return over the time period. In this case, the annualized and cumulative rates of return were boosted by depressed stock market valuations at the start of the measuring period, in 1974.
The client account includes investment in foreign securities, which involves greater volatility and political, economic, and currency risks and differences in accounting methods. The S&P 500 Index is a market-value-weighted index consisting of 500 stocks chosen for market size, liquidity, and industry-group representation. The S&P 500 Index returns include reinvestment of dividends. The volatility and other risk characteristics of the S&P 500 Index may be greater or less than those of the client account. You cannot invest directly in an index.
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