Bull!

by Maggie Mahar

  Trouble is, “momentum investing” works only in bull markets. When the cycle turns, momentum reverses, and investors quickly discover that last year’s high-risk winners are this year’s high-risk losers.

  But in 1996, few mutual fund investors worried about the cycle reversing. That fall, a Lou Harris poll showed that 84 percent would hold their funds or buy more shares if the fund dropped 20 percent in value. Not that they expected a downturn: only 15 percent of mutual fund investors thought that stock prices might fall over the next six months, while more than half (56 percent) truly believed that over the next 10 years, the stock market was likely to match the 14 percent annual return of the preceding 10 years. In fact, nearly a third (29 percent) dreamed of egg in their beer, predicting that over the next decade, the market would return more than 14 percent a year.26

  VALUE VERSUS GROWTH

  As the indices levitated, “growth managers,” who favored airborne stocks, took home the trophies, trouncing “value managers” who scrounged for bargains. Late in 1995, Barron’s reported that funds willing to pay top price for high earnings growth were up some 40 percent for the year—while the average value fund had gained just 22.4 percent.27 Far from a pittance, but investors who saw their neighbors making 40 percent felt cheated.

  “I think it’s much harder for many investors to make 10 percent when others are making 40 percent than it is to lose 10 percent,” confided Mark Hulbert. “When everyone else is cleaning up and you’re not…most people can’t stand that. On the other hand, when they lose 10 percent, they become philosophical—as long as everyone else is losing 10 percent too.”28

  The basic truth—that everything turns on the price an investor pays when he buys a stock—was falling out of fashion. “This is when the value strategy began to be discredited—it got worse in ’97, ’98, and ’99,” recalled Jean-Marie Eveillard, a veteran value investor who ran the SoGen funds.29

  Traditionally, value investors aim to buy $1 of growth for 50 cents. But cheap alone is not enough. “There is a misperception that value investing is cigar-butt investing—buying the moribund leftovers of the market,” observed Christopher Browne, a directing manager of Tweedy, Browne Company, an 80-year-old investment firm. “In fact, we’re the best growth investors around. Growth funds report an average annual turnover of 120 percent; ours is 10 percent. We thought the idea of buying a growth business was to buy something you could hold on to,” he added mildly. “After all, management is compounding value.”

  Growth investors flip stocks like houses in the Hamptons “because they’re interested in short-term results, and the illusion of control,” Browne suggested. “They’re like the guy you see on the turnpike weaving in and out of lanes. He gets ahead of you. He gets behind you. He gets ahead of you.” And if he’s investing, he pays taxes on short-term capital gains.

  In a hefty report to clients, Tweedy Browne’s directors quoted Pascal: “All men’s miseries come from their inability to sit quiet and alone.”30

  Every investment strategy carries its own risk. For the value investor, the risk is time. Sometimes, he may have to wait years for a holding to pan out. But he can afford to wait. Typically, he buys a company early in its cycle, while it is still cheap. When an investor gets in on the ground floor, buy and hold makes sense.

  When Bill Miller, manager of Legg Mason Value Trust, bought Dell “at around $1.25,” for example, his downside was limited, the upside steep. Once the stock became pricey, he backed off: “We haven’t bought Dell…in years,” Miller revealed early in 2000. How was he able to guess at Dell’s “intrinsic value” at such an early stage in the company’s development? “If an investor is buying tech stocks,” Miller stressed, “he must thoroughly understand both the economics of the business and the technology.” In other words, the investor needs to understand how the company makes its money. For a value investor, a stock is more than simply a piece of paper trading in the pits, or a symbol flickering along the bottom of CNBC’s screen. It is a share in a business that exists in the real world—with products, profit margins, debts, and rivals. Without understanding it in that context, an investor is making a blind bet.

  JEAN-MARIE EVEILLARD

  A value manager could not hope to outrun the bull that had taken charge of the market in the mid-nineties. He had just two alternatives: hop on the bull’s back and let that wild beast take him (and his client’s money) where it would, or stand his ground and stare it down. The second course of action required equal parts conviction and discipline. Of those who succeeded, Jean-Marie Eveillard would prove one of the most stubborn.

  Eveillard was a survivor: by 1996 he had been steering the SoGen International Fund for some 18 years. During that time, the fund lost money only once: in 1990, it fell by 1.7 percent. But what was remarkable was not just that Eveillard avoided losses: in the 19 years ending December 31, 1997, the fund returned, on average, 16.20 percent a year. Over 10 years, the fund averaged 11.99 percent. When its 10-year record was adjusted for risk, that translated into 18.62 percent.31 In other words, Eveillard was that rare animal—an equity fund manager who endured both the late seventies and the crash of 1980–81 and emerged with double-digit returns.

  Born in France in 1940, Eveillard took a longer and more philosophical view of time and change than many younger, American-born fund managers. Although he had been in the United States since the sixties, Eveillard still spoke with a mild Gallic shrug more than 30 years later: “All markets are cyclical,” he said, accepting the inevitable. “This means that, by definition, all value investors are market timers. We refuse to participate in the last few years of a long bull market because those last few years are when you get a speculative bubble.”32

  Granted, an investor did not have to be French to appreciate the role of cycles in stock market history—and the risks inherent in investing toward the end of a strong cycle. Eveillard belonged to a small, international circle of experienced investors who would refuse to be seduced by the bull. By 1996, many realized that valuations were growing far faster than value: share prices reflected earnings estimates that outstripped the profits that the market’s favorites could realistically hope to earn. One clue that something was amiss was the fact that share prices were now beginning to grow faster than the gross domestic product (GDP). Since the growth of the stock market reflects the growth of the economy, it was clear that this situation could not continue indefinitely. In fact, history shows that over time, earnings growth lags real growth of GDP.33

  “First the bubble came in large-cap growth stocks—stocks like Coca-Cola—and then later, in ’97, ’98, and ’99 in technology, telecom, and the media,” Eveillard recalled in 2003. At the time, he realized the hazards of investing in a market where prices are set by true believers. (If you are going to play cards for money, you do not want to play with lunatics. It is too difficult to guess what they might do next.) “The market had been going up for more than 10 years, and psychologically, the longer it goes up, the more people believe it will go up forever. That’s not the way the world works,” he added. “If you look at history you know everything runs in cycles. But that’s the way psychology works.”34

  By November of ’96, Eveillard was pulling back, trimming his position in U.S. equities to just 22 percent of SoGen’s International Fund, while allocating 33 percent to foreign stocks, 23 percent to cash, 15 percent to U.S. and foreign bonds, and 7 percent to gold-related securities. “We don’t appeal to aggressive investors,” he acknowledged at the time, “because we’re not aggressive ourselves. We only appeal to defensive investors, people who are more worried about losing money than they are eager to make as much money as possible.”35

  In the summer of 1988, Eveillard had withdrawn from Japan, for many of the same reasons that he pulled back from U.S. equities in 1996. “Everything was atrociously expensive [in Japan in 1988] and accordingly we didn’t belong there anymore.” This is what Eveillard had meant when he said that all value investors are, by definition
, market timers.

  But Eveillard was not trying to time the market in the sense of predicting when the Nikkei would peak. He realized that was a rube’s game. “Over the next eighteen months the Tokyo stock market managed to go up another 20 or 25 percent,” he recalled. “But, our attitude is, we’ll play our game, and if it’s no longer our game, we won’t play.”36 In retrospect, he had few regrets. The Japanese market reached its summit in 1989, then plunged, entering a bear market that still had not ended 14 years later.

  In the United States, just as in Japan, Eveillard realized that there was no telling how long the bull would reign. He just knew that he wanted no part of an overvalued market. “There is the historical knowledge that, at some point, the bubble will burst. If I participate in what I think is a bubble, I would expose the shareholders in my fund to undue risk. At some point,” he added, “you have to decide in your own mind whether you see yourself as the steward of the customer’s savings or whether you see yourself as an asset-gathering machine. In the nineties I think most large mutual fund organizations saw themselves as asset-gathering machines.”37

  Of course, on paper, many investors made money in the second half of the nineties. But in reality, only those who cashed in their chips sometime between 1996 and the fall of 2000 took their winnings home. The vast majority of mutual fund investors held on—as they had been told to do, by the press, by their brokers, by the gurus. “I don’t know anyone who got out with massive amounts of money, except some corporate insiders,” noted Clyde McGregor, manager of Oakmark’s Equity and Income Fund.38

  In 1996, however, many of Eveillard’s investors were displeased, and they began to take their money elsewhere. “From the spring of 1995 to the spring of 2000—that was our crossing of the desert,” Eveillard later recalled. “We were still returning double digits in 1996, and yet they were not happy with us.”39 Indeed, beginning in the fall of 1997, Eveillard’s investors began to desert him. By 2000, more than half of his clients had jumped ship, even though the fund managed to return 8.5 percent in 1997 and 19.6 percent in 1999, with just one losing year—1998, when it lost 0.3 percent.

  Eveillard began to feel isolated. “It is warmer inside the herd; it is terribly lonely to be a value investor,” he noted in 1996.40 A few years later, a discouraged Eveillard asked: “If no one else cares about intrinsic value—how do I invest?” It seemed, for a time, that there were neither buyers nor sellers who played his game. In truth, the problem was not that no one cared about intrinsic value. Rather, by the late nineties it seemed that few even believed in the concept.

  “Almost everyone was abandoning us,” Eveillard later recalled. “I don’t mind seeing professional investors I respect do better than me. To see people I did not respect doing better than me—this was truly discouraging.

  “But,” Eveillard added, “as one of my partners said at the time: ‘At least we lost half of our shareholders—rather than half of our shareholders’ money.’”41

  It would take seven years, but Eveillard would be vindicated. As of the end of the first quarter of 2003, SoGen International (now renamed First Eagle SoGen Global) was beating the bear. Over the preceding five years, loyalists who stuck with the fund had reaped returns averaging more than 10 percent a year. Since its inception in January of 1979, the fund had averaged 14.56 percent annually. In 2002, after reviewing the performance of some 372 diversified foreign stock funds, Morningstar named Jean-Marie Eveillard, along with comanager Charles de Vaulx, International Fund Managers of the Year.

  —13—

  THE MUTUAL FUND MANAGER: CAREER RISK VERSUS INVESTMENT RISK

  The stock market is a no-called-strike game. You don’t have to swing at everything—you can wait for your pitch. The problem when you’re a money manager is that your fans keep yelling, “Swing, you bum!”

  —Warren Buffett,

  1999 Berkshire Hathaway Annual Meeting

  ACCUMULATING ASSETS

  In many ways, Eveillard was lucky—he ran his own shop. Had he worked for a large fund company, he might not have had the luxury of choosing whether or not to participate in the run-up. “At the large mutual fund firms there was an institutional imperative to play the game, and the game meant that you had to have 35 percent of your portfolio in big cap stocks,” said Oakmark’s Clyde McGregor.1

  Big-cap stocks drew customers, and as the largest fund companies vied to divide the pie, many became what Eveillard called “asset gathering machines.” After all, in most cases a firm’s profits turned on how many dollars it had under management, not how well it managed those dollars. At some firms, managing the portfolios seemed almost a second priority.

  This is not to say that performance was irrelevant to a mutual fund company’s earnings. Far from it: research showed that investors rewarded those that ranked at the top of the charts by pouring new money into their funds. But while investors were likely to chase a fund that outperformed, they were much less likely to punish a fund that lagged. Sheer inertia, coupled with an instilled belief in buy-and-hold investing, made the mutual fund investor of the nineties loyal. Once a fund company had won his or her assets, it was likely to keep them.

  “You had to have some reasonable numbers,” A. Michael Lipper, founder of Lipper Analytical Services, allowed in a 2003 interview. But in a market that was going up by more than 20 percent a year, that was not too difficult. Most funds were making money, and most investors would stick with them.

  As early as 1987, Lipper suggested that in a burgeoning mutual fund industry, marketing accounted for “about 60 percent of what it takes to succeed.” Another “30 percent” of a firm’s success might be attributed to “customer service,” he said. That left 10 percent for picking stocks and managing a portfolio. “Just generating a good performance record…may no longer ensure a manager’s success,” said Lipper. In fact, mutual fund operators that sold on the basis of performance could be asking for trouble, since “investors who buy performance are often heavy redeemers.”2

  The fund companies’ marketers began to take over the industry. Questions about either market fundamentals or corporate balance sheets gave way to more urgent queries: What sector is hot? What’s moving? What can we sell today? “When a company opened a new fund, the idea came from the marketing guys, not from the portfolio managers,” confided a manager chosen to start an Internet fund at a large Wall Street firm. “I thought Internet stocks were overvalued by then, and that an Internet fund was a bad idea. But that didn’t matter. They knew they could sell the fund.”3

  SHIFTING THE RESPONSIBILITY

  Meanwhile, sector funds were expected to stay fully invested in their industry—not only in the mid-nineties but later, in the middle of a bear market. “Right after September 11, 2001, I bought a couple of defense contractors, and a couple of health care names,” recalled a technology fund manager, “and in the following weeks, these stocks had positive returns. Nevertheless, I got a call from our firm’s risk management guy, from my boss, and from the chief investment officer. All the while, tech stocks are imploding. But I had to write four memos, explaining over and over again why I wasn’t buying pure tech plays. And I still got heat.”4

  On the face of it, it seemed logical that a technology fund should be required to invest exclusively in pure technology stocks: after all, the investors who put their money in that fund had made a decision to allocate a certain percentage of their assets to that sector. Leaving aside the question of how many mutual fund investors actually had the time or inclination to study both asset allocation and the technology industry—and how many put new money into technology simply because the sector was rising—the fact remains that they had invested in a mutual fund because they wanted a professional to manage their money. They expected the manager to use his knowledge, experience, and best judgment to watch over their capital. This is what Eveillard called being a “steward.”

  As technology shares rose to unreasonable heights, a steward’s best judgment might well tell him tha
t he should look elsewhere for value. “In any sector there are times when you don’t want to be buying—the sector has been a favorite for a long time, and now, it’s overpriced,” the technology fund manager explained. “There are no good values. But if new money is coming in, and everyone expects you to be fully invested, you have to buy. If I had a choice, I wouldn’t run a sector fund again unless I could also short the sector, or at least go into cash.”5

  What many mutual fund investors did not realize was that it was up to them to decide when a sector was overpriced. “For an experienced investor who has enough knowledge and time to do the research needed to allocate his own assets, sector funds are fine,” said Don Phillips, Morningstar’s managing director. “But they’re not in the best interest of all investors. I remember, during the bull market, hearing many investors say, ‘If we move into a bear market I just hope my fund manager is smart enough to go into cash.’

  “They didn’t understand that when you invest in a sector fund you’re taking on the responsibility of deciding when you no longer want to be fully invested in that sector,” said Phillips. “And if you take on that responsibility, you have to take it seriously. The fund manager isn’t going to go into cash—his mandate is to buy stocks in his sector.”

  Phillips himself wanted a steward: “I keep all of my own IRA money in the Clipper Fund—a fund that can go into bonds or cash if stocks seem too expensive,” he confided. “It’s a fund that lets the manager go where the best opportunities are. He does the asset allocation for me.”6