The Little Guy Can Win in the Market

A Leg Up On the Market: The Little Guy Can Well Manage It, But It Takes Work by Benjamin J. Stein, in Barrons Dec 11, 1989 One of the smartest people I have ever met, a true genius in several fields, including economics and mathematics, believes in the theory of efficient markets. That is, he thinks that all opportunities for gain based upon known facts already have been discounted into the price of stocks. Based on that conviction, he believes that he could do just as well by throwing a dart at the stock page as he could by doing research himself and buying according to what he found out. Therefore, he buys more or less at random, ad makes a good return when the market is hot, a poor one when it is not, and overall about duplicates what he would make on bank CDs. Another friend, also extremely intelligent, believes that the security analysts and mutual fund mangers of major brokers and dealers already know about as much as can be known about stocks. Their research abilities and staffs dwarf her own, and therefore, she believes, there is no point in her attempting to study stocks and market. Instead, she buys shares in mutual funds. Some have done well. Others have done poorly. Over time, her holdings just about trackor slightly underperform--the Dow. Still another friend, who had apparently been following modern management closely, believes the stock markets are rigged, that top managers will simply steal all good opportunities, and that there is no point in being in equities. He makes a steady, safe, small return in CDs at large banks. Then, there is my friend George. He is also a smart fellow. But he believes that the efficient market is a vague concept indeed. If the market functions to liquidate inefficiencies,1 he wants to be a part of that process. He studies 10-Ks, annual reports, magazines and newspapers, speeches by CEOs. He snoops in legal filing and sometimes visits company sites. From owning investments worth thousands of dollars when I first met him, he has gone to a portfolio of tens of millions today, 15 years later. I know other Georges, too. These people are like little beavers, chewing through data at libraries, reading reports instead of watching Cosby (The Cosby TV show), attending annual meetings instead of boating. These folks investments all seem to make out far better than the Dow, over time, and far, far better than CDs. Then there is little me. I have been speculating, albeit on a tiny scale, since 1958, when I was 13. Over that period, I have observed that the one variable that predicts gains better than any other is the amount of time I have spent researching the company. Where it is high, gains have been high. Where it is low, gains have been low or else there have been losses. Then there is what I have learned from my endless research into management buyouts. The unerring result of my study has been that management or others with the same degree of knowledge as management, make out extremely well on stock transactions involving

Another way to view market inefficiencies is through the eyes of risk arbitrage. Price will eventually move to intrinsic value; the gap will be eventually closed by the market.

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The Little Guy Can Win in the Market

managements companies. Persons who know less than management, or rely on the opinions of security analysts, do far less well. From all this, a conclusion leaps out: Even in the age of machine-generated research, as Michael Milken calls it, even in the age of legions of analyst and instantaneous trades of huge size, it is still extremely worthwhile for individuals to do at least most of their own research. Here are the reasons why, as far as I can discover, anyone with any substantial capital, even of tens of thousands of dollars, is well-advised to do his own research. First, Milton Friedmans brilliant theory of personal gain says that if an individual is directly and substantially at risk, he will work far harder, far more effectively, than will anyone working indirectly on his behalf. No security analyst in a lair on Broad Street can possibly be as motivated to pick stocks correctly as you are when your retirement or your daughters wedding expenses are on the line. Moreover, while many security analysts are undoubtedly well-trained and competent, as a group, they tend to be wildly overworked. They have responsibility for a huge number of stocks, by and large. They simply lack the time to spend significant effort on any one stock. Failing to have that time, they tend to rely on management estimates. Moreover, they often have agendas dictated by their employers. An analyst at even the best brokerage house might be influenced by the amount of inventory of a stock held by his firm, by the wish of another customer to sell, by the need to raise the market before a sale of new securities, or by any one of a number of factors. The individual investor, on the other hand, can pick a small universe of stocks and concentrate on them. He can read everything on the file about say, 10 companies, and get to know them extremely well. Any truly motivated intelligent investor can get to know a stock as well as any securities analyst and usually better. (I was consistently amazed, when I started my work on management buyouts, to find that, when I discussed price with analysts, they were learning from me, freely conceding that they just did not have time to do in depth research about many of the companies they followed.) The individual investor, moreover, need not worry about whether his picks will upset his underwriting department or raise eyebrows at the next staff meeting. He need not attempt to generate sales for the sake of commissions. He need only worry about making money. In terms of motivation, absence of conflicting interest, and availability of time, almost all intelligent investors can surpass all but the very best, most energetic securities analysts. Second, the individual investor can if he wishes, use the accumulated knowledge of a lifetime to augment his study of stockswhich most analysts cannot do. For example, a civil servant who regulated advertising for the Federal Trade commission can form an opinion of which advertising agency has the best executives, responds fastest, seems to executives to have the best management systems. To make stock picks, he can add to that what he reads in balance sheets. No inside information is involved here, but amount of knowledge that no analyst can hope to match.

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A farmer can use his knowledge of food processing; plus some SEC filings, to determine which of these companies are well-run and which arent. And on and on it goes. My friend George is in the entertainment business. His knowledge of it has led to buys of Capital Cities, Warner, Viacom and others that have turned out to be spectacular investments. As for myself, I have an abiding interest in California real estate. Over the past 10 years, I have consistently been able to find stocks with market prices far lower than their asset values. Analysts consistently refuse to see these companies real value, even when they go into liquidation so that the real-estate value can be quickly gotten out. This has provided a chance to buy Southern California real estate in the 1980s at 1960s prices. In my small case, I actually took time to visit some of the real estate in question, research comparable land values, and even hire appraisers (who usually could not get over that I wanted them to tell me the right price and not vice versa). A result of this work was the discovery of large inefficiencies in the pricing of these stocks. As these were rationalized, the stock prices rose, liquidating dividends were paid, and the inefficiencies were somewhat removed. But in the process, I made gains beyond those offered by any stock s on which I have not lavished research time. To be sure, we are talking about tiny magnitudes, but nonetheless about large percentages change. The point is that adding in ones own knowledge and experience to additional research yields worthwhile returns. The analyst in NY, usually wrong, usually without first-hand observation and experience, cannot match the acumen the retired accountant can wield. And speaking of that, retired accountants can often capitalize on the best knowledge base of all. They usually have specialized background in one of two industries, know what is real and what isnt, what works and what doesnt, far beyond the scope of the securities analyst. Moreover, their knowledge of accounting allows them to read the indispensable heart of data about any stock, the balance sheet and its vital accompanying notes. To be able to do this with fluency is a major plus in research. It would shock many people to know how few analysts can do this, or care to do it, or have time to do it, with skill and in detail. Third and closely related to the very fact of an investors removal from lower Manhattan, the individual investor need not be moved by the fads and fancies of Wall Street. Unlike the people who run together at the Downtown Athletic Club and have lunch at the City Midday Club, he need not be swayed by rumors, gossip and fashion. The individual investor can work methodically communing only with fact--a major plus. Nor are the tools of analysis difficult to learn. Modest facility with arithmetic, the willingness to remember detail, the energy to compare and contrast, the same skills that make for success in any analytical enterprise, these are what it takes to study companies. Definitely, some knowledge of where extraordinary profits come fromprice-fixing, monopoly control of markets (another form of price-fixing), and government granted monopolies (ditto) is very valuable. Some idea of what concepts are just selling propositions without real world
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meaning is also valuable, but you can be sure that a few decades of life tell you that better than any number of years of business school. I have never known an intelligent man or woman who tried to master the tools of company analysis and failed do so. There are no arcane formulas, no magic tests learned only on the banks of the River Charles. Stock picking always comes down to common sense, and that usually comes down to a few analytical tools and a lot of work and experience. Well, someone will say, but arent all managements corrupt? Dont they lie? How can I ever make a buck in that world? The answer is that the actively corrupt managers about whom I write often are still (I hope) the exception. The great mass of managers have all the foibles of other humans, but are not purposely working to harm their shareholders. They still tell the investor enough to give a good head start on learning what the company is about whether there is inefficiency worth investigating. Dont dwell on management to tell you everything, but management can start you in the right direction. Yet another person might argue: Well, you may say all of this, but who are you to cite your few miserable examples and say this describes anything useful in opposition to the brilliantly worked-out theory of the efficient market? The answer is, in many ways, the most telling of all. First, the most successful stock buyer in the postwar era, Warren Buffett, says that he personally loves and worships the efficient market theory (EMT). As he has often remarked, that theory so cripples and charms other investors, his potential competitors, that he has a far clearer field to pick his stocks, find huge inefficiencies, and make billions. The EMT, in his view, is unilateral disarmament by most investors. It allows the aggressive investor who does not buy into it to find bargains and make money, unhindered by others trying to do the same. Major gurus like Peter Lynch and my old pal Fred Alger (Go-Go" Money Manager from the late 1960s) say the same thing. The EMT is really an alibi for those who would rather watch football on TV. It is simply not believed, and with good reason, by the Larry Tisches, the Warren Buffetts, the Mario Gabellis, who make the big dollars in stocks. Second, even if you do believe that markets discount every available piece of data that still leaves plenty of room for individual initiative. After all, the EMT does not say that markets become efficient by extraterrestrial means, Individual human beings must read data, compare them with other data, and either buy or sell accordingly. That is, some man or woman must take information and translate it into a price. Why should that person not by you? Someone has to see that the $10 stock is worth $20 and start the move up to $20 by buying in at a slight advance in price. Even such a minuscule speculator as yours truly has done it with

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very small companies. If the market becomes efficient as investors make money on undervalued stocks. Why not be one of them? Of course, even the best investment decisions can be neutralized in the short run by market panics. But again, some advice from Warren Buffett, the master liquidator of inefficiencies, comes to mind. Buffett has said that he doesnt buy markets. He buys companies that are worth owning over the long run, and if the market takes their price down unreasonably, that is just an opportunity to buy more. His ideal holding period for such stocks, he says, is forever. His advice is suggestive only, but powerfully suggestive. Finally, is it worth the time it takes to study a stock? Obviously, that depends on the value of ones time and the size of ones capital. If a man makes $300 per hour and has almost nothing to invest his time is probably not well spent studying stocks. (But a visit to a psychiatrist might be in order.) However, for most middle-and upper middle class people, the research effort is extremely worthwhile. If an investor has a $500,000 portfolio, and spends two hours each week studying companies and thereby raises his return on his capital by three percentage point per year, he make s about $150 per hour for his work. Through the magic of compounding, if he can continue to invest the same amount of time and improve his results by the same ratio, after six years he will have realized a wage of about $340 per hour from his efforts in increased value of his portfolio. This is good pay. Obviously, there are no guarantees. But the individual investor, reading, studying, being his own adviser and mentor, can pay himself well indeed for the effort. The big guys do it, and the little guys who become big guys do it. If you have ever wanted to work for yourself, it is a good way to begin. END Counter-point..

Joseph Nocera: Pro Tells Why the Little Guy Just Can't Win Published: August 13, 2005 WHEN I started out on this new book," David F. Swensen was saying the other day, "I thought I was going to take what we do at Yale and make it accessible to the individual investor." Oh, lucky day! Mr. Swensen, the chief investment officer of the Yale endowment - and to my mind, the best manager of institutional money in the United States - was going to show you and me how to invest the way he does.

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David Swensen To his surprise, however, the book Mr. Swensen eventually wrote, "Unconventional Success: A Fundamental Approach to Personal Investment," published this last Tuesday, turned out to be the opposite of what he intended. Its title notwithstanding, it doesn't show the little guy how to invest like Yale. Instead, it shows why the little guy will never be able to invest the way Yale does. For all the "democratization" that has taken place in the world of personal investing the deck is still stacked against the individual. That was Mr. Swensen's fundamental discovery. And his willingness to change course and turn "Unconventional Success" into a polemic aimed primarily at mutual fund companies, but also at other Wall Street types who fleece the little guy, is to his everlasting credit. After all, he could have told us to buy stocks in companies whose products we buy at the supermarket, like a certain investment genius of a previous era. Any regrets about that advice, Peter Lynch? A YALE graduate and a protg of the Nobel laureate James Tobin, David Swensen took over the Yale endowment in 1985, at the tender age of 31, after a brief stint on Wall Street. Within a few years, he had turned it into the best-run, most influential institutional fund in the country the fund that every other institution wants to emulate. His track record is astounding: over the last two decades, Yale has generated average annual returns of 16.1 percent, a number no one else can touch. The fund itself has grown in that time to over $15 billion from $1.3 billion, even though it now spends over $550 million a year to help cover Yale's operating budget. Even more impressive, though, is the way Mr. Swensen and his Yale colleagues have gone about generating those returns. When Mr. Swensen first took over, Yale's portfolio held stocks and bonds, period. Like most institutional portfolios of that time, "it was neither diversified nor particularly equity-oriented," Mr. Swensen recalled. Today, the endowment has barely 5 percent in bond holdings. "The other 95 percent," he said, "are in places that we think will provide 'equity like' returns."
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Which is not to say it is all in equities. On the contrary, the Yale portfolio is extraordinarily diversified, which both lifts returns and protects against disaster. At the end of the 2004 fiscal year, Yale had a mere 15 percent of its assets in domestic equities, and another 15 percent in foreign stocks. It had 15 percent in private equity, and 18 percent in "real assets," which includes investments in timber and energy. But its biggest percentage, 26 percent, was in something called "absolute return." That is a category invented by Mr. Swensen in 1990. It means hedge funds. Before Mr. Swensen arrived on the scene, hedge fund investors were almost exclusively rich people. But he quickly realized that the best hedge fund managers were extremely skilled, and he began putting Yale's money in a variety of hedge funds. Eventually, other institutions realized that Yale was making money in good markets and bad ones, and they raced to copy Mr. Swensen's model. If you want to understand why hedge funds are exploding these days, a big reason is that every big institutional investor in the country is trying to do what Yale does. His new book has given Mr. Swensen a greater appreciation of the enormous advantages he has as an institutional money manager, starting with the obvious fact that he has a staff that spends full-time researching investment possibilities. Thus, he takes it as a given that individuals shouldn't pick stocks themselves. "I see every day how competitive the markets are, and how tough. So the idea that you can do this yourself, that's out the window." But as he looked around at the alternatives for individuals, he found himself horrified by what he saw - especially at the $8 trillion mutual fund industry, which is the primary means through which individuals invest in the market. Although his prose tends to be on the academic side, his sense of outrage comes through on every page of "Unconventional Success." What is it about mutual funds Mr. Swensen finds offensive? Just about everything. He hates the way the loads and all the hidden fees mean that the investor is always behind the eight ball. (When I asked him about hedge fund fees, which are much higher, Mr. Swensen replied: "I don't mind paying a lot for actual performance. Besides, when we negotiate fees, it's sophisticated investor versus fund manager. It's a fair fight.") He thinks that it is criminal for fund companies to allow popular funds to balloon in size, making it nearly impossible for the manager to beat the market. He hates the way the industry pushes exactly the wrong fund at the wrong time - Internet-oriented funds at the height of the bubble, for instance. (He has one example of a Schwab advertisement during the bubble that is simply devastating.) He notes, as others have before, that the vast majority of actively managed funds underperform. He uses "invidious," "investor-damaging" and "dirty scheme" to describe the general behavior of the industry. Even the mutual fund monitoring companies don't help even the odds. Mr. Swensen absolutely skewers Morningstar, the company that has built its reputation rating mutual funds. His data shows that, like Moody's belatedly downgrading a corporate bond, Morningstar downgrades this or that poorly performing mutual fund only after the damage has been done. His core point, though, is that the for-profit fund industry has a fundamental conflict between its desire for corporate profits and its fiduciary duty to its investors. And the profit motive wins out every time. So does Mr. Swensen offer any hope at all? Some. He thinks we'd all be better off sticking with index funds, instead of trying to beat the market. He thinks we should get our index funds from
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Vanguard, with its rock-bottom fees. (As a not-for-profit company, Vanguard also doesn't have the central conflict of interest.) We should have a diversified portfolio of index funds, for the same reason Yale does. We should be disciplined in our approach, especially in rebalancing our portfolio to stick to our diversification targets. Of course, this invariably means paring back on winners and increasing our investment in laggards. But as sensible, and, in truth, not particularly unconventional, as this advice is, how many of us will actually follow it? Human beings simply aren't hard-wired to be good investors. Think about it: how many of us, really, have the fortitude to pare back our winners and buy more of our losers? Most of us do just the opposite. Heck, so do most mutual fund managers, which is why they can't beat the market either. There is a reason we as a culture have accorded hero-like status to great investors like Warren E. Buffett and Peter Lynch. For all the cultural reinforcement we get that investing is something anybody ought to be able to master, we know in our bones it's not true. Mr. Buffett and Mr. Lynch are like great athletes, who have the skill and the emotional makeup to do something well that the rest of us can only dream about. That describes David Swensen, too. What he has to say is worth listening to. But will we ever truly hear it?

END

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