The year's fourth quarter marks the anniversary of my start in the investment management business many, many years ago. It also happens to coincide with the time of year my three kids go back to school.
Given the heightened volatility that crept back into the markets during late summer (and the fact that my oldest has seemingly morphed into a senior at warp speed), my normal â€œyear in review/plan for the upcoming yearâ€ process grew a little more introspective than usual this time around. In fact, the combination prompted me to do quite a bit of soul searching about what I've learned as a participant in, and observer of, the markets for nearly a quarter of a century.
The result is a distillation of insights that will hopefully prove useful for navigating what may be even more volatile and complex markets ahead. But first, let's set the stage for a little reflectionâ€¦
When I entered this business in 1983, the Dow had just climbed above 1,000 for the first time since the 1960s. The big question on everyone's mind was: â€œWill it stay at that level, or are we destined to have another decade-plus of double-digit interest rates and inflation, as we had throughout the 1970s?â€ Despite the run-up, public companies traded with an average price-to-earnings ratio of around 7 times (versus 15 times today and down from 30 - 50 times in 2000), and industry vets proclaimed â€œNever, ever, pay more than one times revenues for a company's shares.â€ The prime rate, which had fallen by half from where it was a year earlier, hovered around 10 percent. Meanwhile, the capital gains rate had recently been cut from 35 percent to 28 percent.
Average daily trading volumes were regularly less than 100 million shares a day. And, according to data compiled by the Investment Company Institute, only about five percent of the U.S. population owned stock in any form, and the assets managed in the entire mutual fund industry amounted to less than $300 billion. In contrast, today's markets regularly trade several billion shares a day, half of us own equities, and the mutual fund industry has $10 trillion under management. Mainframe computers were still not widely used, the PC was at the dawn of commercialization, there was no Internet, no instantaneous multi-channel news release, and no conference call for individual and institutional investors alike.
It's readily apparent just how far we've come in a relatively short time. This brief reflection illustrates how flexible and responsive the capital system and markets are - not only in the U.S. but, increasingly, around the world. There are bursts, bubbles, downturns, and entire industries that flare and fizzle. Yet the overall trend is unmistakably upwardly biased. Moreover, markets and investors keep doing what they do best: providing a ready source of capital for business, and linking ideas with backers in a wide host of industries all along their growth trajectories. Given all this what insights have I gained from nearly a quarter century of observation?
Wall Street, given its dollar-denominated and dollar-dominated nature, has attracted the best and brightest of technological personnel and innovation. From highly sophisticated performance-measurement systems to trading algorithms and complex intra-industry analyses, the sense of precision and presumed predictability has never been greater. Yet people are still ruled by prehistorically wired brains and subject to both crowd behavior and emotional reaction. The same basic extremes of emotion - greed to fear and then back again - rule most market cycles, much as they have since the first recorded bubble (over tulip bulbs no less) in the 1600s.
Because we are all human, it's important to realize that no one is â€œtoo brightâ€ or â€œtoo highly placedâ€ to screw up. Three Nobel laureates nearly brought down the financial system in 1998 with the collapse of Long-Term Capital Management. And a very bright CFO of Orange County, Calif., was at the helm when that county declared bankruptcy (based on unexpected outcomes of various debt obligations in its portfolio). Common sense in developing and working your own investment program may well serve you better than the best placed purveyor or highest-powered computer.
One of the most basic concepts underlying a free-market system is that assets or services change hands at a mutually agreed upon â€œclearing priceâ€ (i.e., what one party is willing to sell at and another is willing to buy at). Yet in public-asset markets there often are times when asset prices become overvalued or undervalued - driven more by emotion and word of mouth than true fundamentals. In the words of Oakmark Principal Howard Marks: â€œThere is no level of fundamentals that can't become overpriced.â€
While interim trends can sometimes carry on for longer than expected, markets eventually return to rationality, and things right themselves. Stocks won't continue to go up if earnings disappoint. Stocks won't continue to go down if earnings continue to surprise on the upside. It pays to be patient and watchful. The primary consideration for any investment - either one you own or are considering making - is the current price relative to its inherent, intrinsic value. Interestingly, it seems the longer something stays at an extreme, the more brutal the eventual reconciliation tends to be (as witnessed in the dot.com bust or the â€œrightingâ€ of financial institutions brought on by the S&L crisis).
Investing against prevailing trends can be an excruciatingly painful exercise - particularly when these trends have persisted, and the popular press has declared why â€œit's different this time.â€ It may also be difficult to differentiate between fads (â€œnew economyâ€ stocks) and shifts in long-term trends (such as tolerance for a lower level of unemployment relative to inflationary fears). In such cases, the application of common sense is again a good fallback. I recall when satellite TV companies were all rushing to go public. If you added up the subscribers they each intended to snare in the subsequent few years, the aggregate far exceeded the U.S. population. But most satellite stock offerings went off with great fanfare, rocketing mightily in early trading. For investors who believed in the technology, it was exceedingly tough to stand by during this overvalued phase and wait until prices more accurately reflected reasonable expectations.
Risk is an unavoidable part of life. In assessing financial risk, the key is to understand probabilities, evaluate likely outcomes, and consider how they relate to your specific situation at a particular point in time. As an example, let's assume you and your business partner are considering investing in a new franchise unit. Let's also assume you have two children in college, and this investment will take the majority of your free cash flow for the next five years. You are likely to view risk in a different light than your partner, who has already educated his brood. As in every aspect of life, you will assess and balance trade-offs - and ultimately, evaluate the success or failure of your choice(s) to help improve future decisions and long-term success.
As previously noted, investment decisions should start with a thoughtful analysis of the current asking price relative to intrinsic value. In addition, the probability of one economic or financial outcome versus another should be considered. Both of these processes help you to evaluate and then create a space between an investment or financial decision that may make or break you - in essence, a â€œmargin of safety.â€ To illustrate, we need look no further than the past year. As markets rallied nearly 20 percent between the summers of 2006 and 2007 (reaching new highs), some pundits began to wonder if they were gearing up for a blow-up similar to that of 2001 - 02. However, what has been virtually ignored is the fact that average market earnings (as measured by the S&P 500 and reported by data aggregator Thomson Financial/Baseline) are projected to be nearly 70 percent higher when this year's numbers are final versus their 2000 level. Consequently, the market's valuation was less than half what it was in 2000, arguably providing a larger margin of safety than that of the prior period.
With the advent of increased computerization, the sophistication and proliferation of financial instruments and management styles has been mind-boggling - including options, futures, hedges, collateralized debt obligations, strips, iShares, etc. Yet, no matter how sophisticated or exotic the products get, the three basic categories of stocks, bonds, and cash can serve the majority of one's investment needs. (For more on this topic, see â€œAsset Allocation 101,â€ my column in the third quarter 2006 issue of Area Developer.)
Markets can be brutally, excruciatingly, mind-numbingly emotional. If you know you are more prone to being swayed by the advice of friends, headline angst (or exuberance), etc., be sure you've carefully thought through and thoroughly documented your plan. Do it on the weekends when the markets are closed. Don't listen to the chatter of the financial news networks, and find a couple of good long-term â€œwisdomâ€ sources to guide your thinking and point of view.
In actuality, very few family fortunes have been made in the market. Most are made elsewhere. On the other hand, compounded growth of 6, 8, or 10 percent per year adds up nicely (even if inflation eats away at 2, 3 or 4 percent of it). Set your sites on searching out well-diversified methods for achieving steady and consistent growth, rather than concentrating efforts or assets in high-risk/high-return ventures.
Leverage is a lot more fun to have when it increases your return, rather than when it serves as an albatross in down markets or tough credit environments. Similarly, volatility is much more enticing when it means double-digit increases on the upside. However, both are endemic in the investment/financial/capital arena, and the price we pay for having open markets and functioning systems. It's also important to be mindful that, while volatility has gained a negative reputation in most individuals' minds (since it means things move around with much greater frequency), it brings with it plenty of extra opportunity for those who are willing to take the time to develop and implement long-term strategies.
When considering a wide array of financial issues, from a public stock to a service provider, consider how management or the people marketing the asset or service are rewarded. If a broker is paid on transactions rather than growth of assets, or a CEO's bonus is based on their company's stock price, or underwriters' bonuses are tied to quantity of loans underwritten rather than quality, where will their respective passions lie when the going gets tough? You decide.
When all is said and done, the markets have proven they can be amazingly frustrating - and also amazingly exhilarating - venues in which to spend one's days and invest one's hard-earned assets. For those willing to apply a few time-proven rules, the long-term results can be quite gratifying.
Carol M. Clark, CFA, is a partner and investment principal of Lowry Hill Private Asset Management, a comprehensive wealth management firm providing proprietary investment management and financial services to families, individuals, and foundations with wealth greater than $10 million. The firm manages more than $6 billion in assets for 300 families and more than 60 foundations from its offices in Minneapolis, Naples, Fla., and Scottsdale, Ariz.
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