Friday, December 23, 2011

Thirty Years and Counting


I will be on vacation next week, so this will be my final posting on Random Glenings in 2011. I thought I would take a break from the usual economic/market commentary and take a brief look back.

All the best for a happy and prosperous 2012!

Thirty years ago, in December 1981, I graduated from the Business School at Indiana University. Against the advice of my professors, I decided to head east, and start a career in investment management.

The investment management business was considerably different than it is today. After the "Go-Go Years" of the 1960's - when mutual fund managers like Gerry Tsai at Fidelity had achieved an almost cult-like status by achieving spectacular returns - stocks had fallen to earth in the 1970's.

The Dow Jones Industrial Average hit 1,000 in 1969. The market then started the slide that would take the Dow below 600 in 1974. Gradually prices improved, but it wasn't until 1982 - the year that I started my investment career - that the Dow returned to the 1,000 level.

Investors fled stocks in the 1970's for safer havens like bank accounts. The industry greatly suffered - Fidelity, for example, nearly went out of business in the decade, saved only by the introduction of money market funds.

There was more. Academic research indicated that markets were mostly efficient - that is, all available information about a stock was already reflected in its price, and there was no need for fundamental research. Why should anyone pay for investment advice if the markets were totally efficient?

Individuals were largely not involved in the stock market. In 1980, less than 10% of the American population had any of their net worth tied up in stocks. Stock market activity was an interesting news item, but it had a minimal impact on the daily lives of most people.

The firm I joined - Scudder, Stevens & Clark - was the oldest independent money manager in the United States. Scudder managed $12 billion when I joined it - the largest money manager in the country.

Scudder's investment business was largely focused on high net worth investors. We had some prestigious institutional relationships - the Ford Foundation and Harvard University were large clients - but most institutions were more comfortable with large passively managed bond portfolios.

Scudder too had experienced rough times in the 1970's. All of the partners had been required to pony up money to keep the firm afloat in the bear market that never seemed to end. Salaries were low - no one went into the money management business to get rich.

The firm was understandably frugal when it came to expenses. A sign in the Men's Room reminded users that "It only takes a little soap, and lots of water, to get your hands clean". The expense of personal long distance calls were the responsibility of the employee, and monthly phone bills were carefully monitored.

I was heavily in debt by the time I finished business school, and asked Scudder to help pay for my moving expenses. Reluctantly they agreed, but only after I got several competing bids from moving companies.

Even so, I had to wait more than a week after I started at Scudder for my furniture to arrive. A sleeping bag, and one pot for cooking, were the total sum of my furnishings during my first days in Boston.

It goes without saying that my salary was nothing special, either. Although I was one of the top students at Indiana, my starting pay at Scudder was well below average compared to my fellow graduates.

Scudder's attitude towards paying new employees was best summarized by Ted Scudder, in an excerpt from a speech that all new hires were required to read:

"Right now you are worth less than nothing to us, since you have no clients or investment expertise to help the firm. Still, we realize that you could not work with us if we did not pay you, but you should be aware of the sacrifice that the partners are making on your behalf."

Even with all of this background - low pay, crummy markets, frugal management - I was thrilled to be working at Scudder.

Scudder had almost a family-like culture. Everyone worked hard, but family and friends were important as well. When an employee suffered a personal loss - as I did in my early years - no one could have been more supportive than the management of Scudder.

But the business of Scudder was managing money. Fortunately for me, it was a great time to be an investor.

Stocks were trading at single digit multiples, and dividend yields were well north of 5%. Rather than talk about opportunities, however, the media largely focused on how poorly stocks had performed in the 1970's. No one had any interest in buying a piece of a business whose growth rate was far ahead of where it was being valued in the market.

Bond yields had steadily risen throughout the 1970's as inflation rates steadily moved higher. By the late 1970's, inflation was running at double digit rates, and new Fed Chairman Paul Volcker decided the time had come to slay the inflationary dragon. The Fed's policies eventually worked, but at a cost of extraordinary high interest rates.

Thanks to Paul Volcker, when I started at Scudder short maturity rates were nearly 20%, and long maturity Treasury bonds yielded more than 14%.

With record high short-term rates, money market funds were the rage. In 1981, money market funds had returned in the neighborhood of 15% to investors. Few observers bothered to point out that high short term rates would certainly be short-lived; in fact, Volcker started to cut rates in August 1982, and money market yields quickly followed suit.

My first assignment at Scudder was a corporate bond credit analyst. Investors could make serious money by doing fundamental research on bonds, and Scudder was one of the best. Since Scudder was literally the only investment firm that devoted any resources to bond research at the time, I can safely say that I worked in the best bond research areas in the country.

It is obvious in retrospect that investors should have been throwing any savings they had into the markets, but after the Lost Decade of the 1970's no one had the stomach.

For the period starting in January 1982, and ending at the end of 1999, stocks produced a 19% compound annual return. Even long government bonds gave anyone brave enough to invest in the market a 13% compound annual return.

If there is one constant that has remained the same over my 30 years in the business, it is this:

Investing on the basis of past returns is nearly always a bad decision.

And the corollary to this is:

Reversion to the mean is one of the most powerful forces in the capital markets.

Over most periods of time, stocks will outperform bonds. This only makes sense: an investor in a company should earn higher returns than someone who lends to the company. Returns from safe cash investments like money market funds have historically returned the rate of inflation, which also makes intuitive sense.

Or, put another way, no one ever got rich investing in money market funds.

Investors in 1981 were not interested in stocks or bonds because they had performed poorly over the prior decade. No one focused on valuation, or was able to see that most of the investment worries were already priced into the market.

Smart investment managers like Scudder tried to point out the opportunities to clients, but very few would listen.

Which brings us to today.

Similar to the start of my career, stocks have been disappointing performers for the past 12 years. Looking squarely in the rear view mirror, investment thinking today focuses largely on the myriad of risks in the market.

Investors would rather buy Treasury bonds yielding less than 1% for 5 years rather than subject their capital to any possible risk. Again, this is similar to where I started, when investors flocked to money market funds.

Alternative investment vehicles like private equity or hedge funds have gained appeal among institutional investors based on past returns. Never mind that some of these gains have been earned by taking outsized risks.

Instead of buying large cap dividend-paying stocks offering all-in (earnings yield + dividends) yields around 15%, investment committees would rather place their funds which the latest "hot" manager - just like Gerry Tsai at Fidelity in the 1960's.

There is one major difference between today and 30 years ago: the public.

In 1982, most workers were covered by some sort of pension plan. It was not necessarily to invest in stocks since your employer paid your retirement benefits.

Today this has all changed. Pension plans have largely disappeared - even public plans are trying to force employees to convert to self-funded retirement vehicles. Workers may not want to learn about the stock market, but they really have no choice.

More than 70% of Americans today have some exposure to the stock market, and their recent experience has obviously not been positive. Convincing the average investor to focus on long term returns - especially when it comes to retirement savings - is obviously a challenge.

But in my opinion, if investors have any hope of having enough money to enjoy their retirement years, a significant portion of their savings will have to be placed in common stocks. The potential outcome of returns from nearly every other asset class is simply too unappealing to reach any other conclusion.

I've been lucky to be involved in the investment management business for the past three decades.

And while I'm not sure what is in store for the next 30 years, I'm looking forward to writing another long post about the past in 2041.