Monday, May 31, 2010

On Memorial Day,
and the Future Leaders of the
Investment Community

On this Memorial Day weekend my first thoughts turn to the ordinary people who have been our extraordinary heroes and heroines, who gave their lives and bodies so that we can be free of imposed dictatorships. One of the characteristics of wars and most conflicts is that they are battles between offense and defense. Rarely can one succeed without relying on both sets of skills.


As I write this blog, I am exercising my freedom to think about the war for the survival of our investment capital. Military wars have alternating offensive and defensive phases which often pivot on the success or failure of both new technology and more importantly, new applications of human behavior. Think about the language in the press, quoting many participants throughout 2008 and during this month of May, 2010. Frequently one reads about someone saying that they were “killed” or “mauled” by the fall in the market, and more recently by sharp spikes. The terms of war appear to be appropriate in describing this battle for the survival of our investment capital.


Wars are won and lost by exceptional leaders and by using resources more intelligently than the opposition. Often the battle leaders have something in their background that one can point to as common among them. There have been a couple of graduating classes at West Point "where the stars fell." The leaders (generals) from these classes led us through our bloodiest wars. I had the distinct honor and good luck myself to be the member of an extraordinary class in the US Marine Corps’s Basic Officers Class. Out of a class of six hundred peacetime Marines, we had six members who became general officers, including a future Commandant and another four star general. (I believe that this was the first time the Corps had two four star generals at the same time.) In addition to the military success story, my class also included a number of very successful civilians in many walks of life. With this as a background, the members of this blog community will not be surprised to learn that I have been an analyst of leadership for most of my adult life.


As the background of leaders change, so does the way battles are fought. Until recently, the investment leaders were either solid, surviving investors or were salespeople who could deliver good investments. Since the 1930s the Bible for professional investors has been Graham & Dodd’s Security Analysis. I had the distinct honor to study under Professor David Dodd, and more importantly, Warren Buffet studied with Ben Graham. The original text and the six later editions discussed the various ways to make sound investment decisions. To the best of my recollection there was nothing about how to place or execute securities transactions. For the next couple of generations, equity analysts trained to become portfolio managers, who gave buy and sell orders on the various stock exchanges to “clerks” to execute. Over time these so-called “clerks” became professionals in their own right and some were admitted to ownership of their firms. As is often the case, the bond market was ahead of the stock market. Bond portfolio managers sat on the fixed income trading desks. Bonds trade largely in the over-the-counter market of occasional limited liquidity and discontinuance prices. Bond portfolio managers added or subtracted value due to their trading skills. As a student of fund performance I have seen that the relative performance results of a bond manager has more to do with making correct trading decisions than correctly anticipating interest rate moves.


In response to the growing professionalization of trading beginning in the 1990s, I started to see the hiring of traders as portfolio managers initially by and for hedge funds. These traders were often well trained at various hedge funds and proprietary desks of brokerage firms. In a vast over-simplification, the traders knew what was moving and they believed that a stock was only worth what it was selling for, not a discount from some future value. As these traders became more successful (and for political reasons the community was destroying the quasi-monopolistic power of its center), the skills of traders became more important. Various new market centers were created, both as exchanges and private markets. One of the keys to their success was the speed in which they could trade. The speed of trading depends on the speed of information transfer so trading technology has become critical.


As the equity world woke up to this change (similar to surface ships recognizing the risk from torpedoes and aircraft), the intellectual leadership began to change. Instead of hiring liberal arts majors who could “think” and develop models of future values for companies, they hired PhDs with math and physics backgrounds. These “rocket scientists” from Caltech, MIT and Carnegie Mellon among other schools, became the bonus babies for “The Street.” (Bias is showing in that I am a trustee of Caltech, MIT bought mutual fund data from me years ago, and I have a freshman nephew at Carnegie Mellon.) The tasks of the rocket scientists were to determine the likely trajectory of the missile, (in this case, the next price) and intercept it for a brief moment. They were being wired to make very rapid, small, frequent gains or cutting their losses very quickly. As this kind of thinking became the dominant market leadership mode, I saw major changes in relative fund performance leadership. Due to the intraday induced volatility, trading added more than investing in many instances.


Some great past performance leaders did not master the new art. I saw a similar thing happen in the market break in the late 1960s, where two performance leaders had similar spectacular performance on the way up and very different on the way down. While they owned similar and perhaps identical positions, the one that lost less sold his most liquid positions first. The lesser performing fund attempted to sell his most illiquid positions first. What is important in this leadership example is that in the subsequent recovery, the loser kept a significant cash reserve for the first time and the winner went back to his old, almost fully invested portfolio. In effect, the loser and his shareholders lost their nerve. In time the loser who still had some good performance retired and was replaced


I believe we have gone through at least one, if not multiple, inflection points and I expect the next new class which will have stars fall on its shoulders has graduated from law schools and is now getting into position to seek fortune. At this present time, we have about half the scenario for the next leadership battle. We already have, (and are getting more) data as to the instability in the marketplace. What is missing is the regulatory response. New national and international rules will be put into place that will attempt to fight the last battle. The rules will have all the benefit of the Pentagon’s past favorite practice: to fight the last war brilliantly on paper. They do not focus enough on how the future will build on the past.


The new rules will attempt to constrain various perceived ills. The constraints will add a level of complexity that will retard many. There will be some that will actually read the various regulations, and some more will understand the reporting technology put in place. By seeing things more bureaucratic minds will miss (the signs of a good lawyer), they will find new ways to make money. This will be not the first time that legal training led to investment success. One example, and there are many others, is “Mr. Johnson.” A Boston-based lawyer in the 1940s, Mr. Johnson had the opportunity to buy the ownership of one of his clients, which he renamed Fidelity Management & Research. Everyone including his son Ned referred to him as “Mr. Johnson.” For approximately thirty years it was his skill in seeing investment and marketing opportunities that others missed, that became the foundation of what Fidelity is today. He encouraged young associates to research stocks with same vigor as an attorney in preparation for an important case. He saw through regulations and practices that others didn’t.

What should we do now? We should be looking for new leadership to be our investment heroes, some will come from an understanding of the law.
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