This statement seems counter intuitive to the practice followed by most of our great non-profit institutions. I am going to use as my point of departure a talk given by Jeremy Grantham, a very original and thoughtful thinker who is the CEO of GMO, a Boston-based investment management group. Jeremy’s October 7th, 2009 talk was entitled “Friends and Romans, I come to tease Graham and Dodd, not to praise them.” The talk focused on the potential disadvantages of Graham and Dodd-type investing. A little background may well be helpful for the members of this blog community who are not professional investors and/ or securities analysts. Columbia University is extremely proud that both Benjamin (Ben) Graham and David Dodd taught at Columbia and wrote the fundamental bible for analysts, not surprisingly titled “Security Analysis.” I had the great experience of taking the course under Professor Dodd when Ben Graham had fully returned to his investment management activities. The essence to the text and the course was to seek out value as the basis for investing in both bonds and stocks. This task was to be done by professional analysts using financial statements to find stocks and/or bonds selling below their current value. I remember arguing with the good professor, that while finding price disparity was nice, it was likely to produce a lower return than by finding prices that did not adequately reflect future value. While Professor Dodd did not totally disagree with me; he felt that there was less risk of loss by pursuing value than by following a future-focused growth approach. (At the time I was not conscious of the investment career of one of Ben Graham’s students, Warren Buffett. When Buffett looked at an underlying business, he created sensible measures of quality not found in financial statements, thus adding immensely to the valuation equation.)
Jeremy’s main criticism of the value-oriented investors is that they are not sensitive to the extremes in the marketplace. The value investor conducts his or her investment search the same way in up and down markets, always looking for the cheap jewels in the expensive weeds. This practice can lead to many years of gains which leads to value investors focusing exclusively on the search for value, as defined by low price/book value. Jeremy points out that when cataclysmic changes occur in the market, these investors are not prepared. At the 1932 bottom, 41 years of previous gains were lost. Ben Graham lost 70% in that market collapse, in part because he was on margin (using borrowed money). Among the others who lost a bundle earlier in currency speculation were Lord Keynes, also a user of margin. Some more trading-oriented investors recognized the extremes, like Roy Neuberger, who was short (selling shares that he did not own, but borrowed) going into the crash.
Two Critical Questions
Two critical questions came out of this experience. The first is to question the effectiveness of diversification, an accepted part of investment dogma today. The goal is to hold many assets that don’t go down at the same time, thus preserving capital. The only problem with this principle is 2008, when practically every asset class around the world rolled over into a decline of mammoth proportions. There were some, very few, investors who did not suffer substantially. I personally know of no investment committee-led institution that avoided the decline, but I do know of a few individuals who appeared to have escaped the onslaught. This realization leads us to the second critical question: Why did so many investment committees, made up of honest, hard working, investment professionals (our British friends call them “worthies”) have such bad performances?
There are two parts to the answer. The first is that the legal charge to fiduciaries is to act prudently. The guiding principle comes down from the ruling by Judge Putnam in 1830 in Harvard vs. Amory, where Harvard lost the case because it did not act prudently. “Prudently” was defined as how other men of intelligence and prudence would have acted in their own accounts. In effect this set up peer-focused comparisons. This was the intellectual foundation of the Lipper Mutual Fund Performance Analysis, which made money by creating appropriate fund peer groups and measuring performance for mutual fund directors. Thus, a fiduciary that is doing approximately the same thing as his/her peers, is being prudent whether the account is going up or down in value. While this prudence fulfills the minimum requirements and answers the career-risk issue for trustees and investment managers, it does nothing to fulfill the desires of the client. The non-profit needs to pay operating expenses and occasionally capital expenses, therefore it may not be well-served by “prudently” losing money. Why then are some individuals better able to produce results than the combined brain power of a group of the worthies?
The second answer is best summed up in a quote that Jeremy uses from Warren Buffet. “The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merits, the investment is inevitably too dear and therefore unattractive.” The very function of an investment committee leads to prudent actions. I am currently chair of three different investment committees. I find that after an informed, polite discussion, a consensus is formed which rarely calls for taking an extreme action. Members of all of my committees are well-meaning people who have volunteered their time (and quite often their capital) to the institution. We almost never have the sharp disagreements that often occur within corporate or family partnerships. I wonder whether the pleasant decisions are of the same quality as the more intense discussions?
Individual vs. Group Decisions
I believe that Warren Buffet would suggest that at critical turning points, an individual’s decision-making is better than even an intelligent group decision process. Buffett might even favor a strong personality over an agreeable one. I know that trustees that do not ask the tough questions are not acting in the long term best interest of their institutions. They should find their friends elsewhere.
One of my sons and I will see whether Warren comments on this topic while we attend his annual meeting next Saturday. Stay tuned.
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