When Experience is not the Best Teacher

In my book Money Wise, I began with the desire to explore the principles of investing to find laws of certainty similar to that found in the physical worlds. I have been unable to find these supports in terms of securities selection or in portfolio decisions. Many others, however, have believed that they have found such rules.

One can often learn more from reading the apology letters from poor performing funds than from winning funds. Brandywine Funds is one of the better communicators of this group. Their basic investment approach is to invest in stocks that they believe are selling at a discount to a future price, based on their estimate of future operating earnings. In bemoaning their under-performance, they focus on the “Quality Ranking System” of Standard & Poor’s, an analytical approach that focuses on relative growth of earnings and dividends over time. Using letter grades to signify the best of these measures, S&P assigns “A” to the best and “C” and “D” to the worst. In the first nine months of 2009, the “C” and “D” companies gained on average 134%, while the high quality “A” stocks were up 21%. To add insult to injury to the earnings modelers, the best performing stock in the Russell 3000, Human Genome Science, was up more than 3,300%. The company has not reported an annual profit since 1994, and is expected to have larger losses in 2010 than in the current year.

Another currently poorly performing manager focuses on the fact that the companies reporting earnings gains often are doing so by significantly reducing expenses. In many cases they are also experiencing reduced sales and/or share of market. Yet in the current market, these stocks are substantially outperforming others that are showing revenues gains and increasing or maintaining market share. Consumer stocks are doing well on Wall Street, but not on Main Street, and they have attracted significant short interest.

Under normal conditions, the focus on accelerating earnings produces performance leaders. The apologists for current relative poor performance have, in some ways, been bitten by one or more Black Swans. In the nineteenth century many Europeans believed that all swans were white, thus there was shock and consternation when they were introduced to Black Swans from Australia. This introduction violated their experience. For hundreds of years before the early twentieth century, the world was an orderly place following the rules of science as pronounced by Isaac Newton. Then Albert Einstein’s thoughts changed the way we looked at the world. In these two instances we are confronted with the choice of the experienced and normal, but recognize that under some conditions exceptions will occur.

Our market and economic experience over the last two years does not follow the normal past experiences. We clearly have been in an exceptional time. History suggests that past exceptional periods eventually coalesce into some form of repetitive patterns that become the new normal. I am not sure what these new relationships will be. PIMCO believes that they have found the new normal, which produces more subdued growth. I am not sure. In view of the fact that, in general, equity returns for the last ten years have been flat, I am of the view that over a longer period we will see growth. My feeling is that at least we will see high single digit growth with some years, like 2009, showing double-digit gains. Further, I believe some form of the old “normal” rules will work for investors, perhaps when we least expect it to work. In other words, this is not like saying to hold on to your Confederate Dollars. But rather, it is a recognition that the South did recover eventually, and is now often a growth leader.

Keep an eye on formerly successful managers, for some of them may be future leaders again, particularly if they do not chase the new normal.