I will admit that I claim to be a member of the human race and take full ownership of all the baggage that comes along with this claim, including those little bits of human nature that want to be something other than average. So I work an extra hour or two in hopes that I gain a bit of knowledge that will be rewarded. A couple extra hours of work doesn’t mean much unless you multiply those few extra hours a day by the number of days it takes to cover three decades. I will admit that it has paid off. But it took two of those three decades of extra effort before I could claim any rewards.
With my confession I hope you will understand why I would say “The S&P 500 has not been particularly difficult to beat…”. I do believe this statement, but the words are not mine. They are the words of John B. Neff, CFA spoken during the question and answer period of a presentation he gave to the 2006 Financial Analysts Seminar held in Evanston, Illinois. The question was: Do you think active managers can outperform the S&P 500 Index over extended periods? Before I share his answer with you, I want to introduce John.
In 1964, John was appointed by his employer, Wellington Management, as the portfolio manager of a small mutual fund that the firm was hired to take care of on behalf of The Vanguard Group. The fund was named the Windsor Fund. During his tenure as portfolio manager, the fund became the largest mutual fund in the country, even though it was closed to new investors in the 1980’s. Of course you don’t become the largest mutual fund in the country without providing some benefit to the investors. John never let them down as his work resulted in being recognized as the best performing mutual fund in the country.
During the 31 years of his stewardship, the fund produced an average annual return of 13.7%, versus the market’s annual return of 10.6%. His fund outperformed the S&P 500 22 of these years and barely missed the mark in a few more. The real impact of his work had to do with the difference this small, 3%, outperformance provided his shareholders. A $10,000 investment in the Windsor Fund with dividends reinvested grew to $535,272 in those 31 years while the same amount invested in the S&P 500 ended up at $227,200. In this case, those human beings who believed that you could actually outperform the markets and stayed invested throughout John’s tenure, walked away with an extra $308,072 in their pocket. Not bad for being a fool!
The sad fact is that our human nature never would have allowed any normal person to have obtained the total return on the Windsor Fund in those 31 years other than John himself. Most people would capture a few dollars of gain by selling or exchanging the shares into another fund. Others spent their windfall early on. We may recognize patience as a virtue, but when it comes to investing it is almost an impossible trait.
We know this from how long individual investors (and professionals alike) hold on to their investments. The average holding period for professional mutual fund managers is less than twelve months. For them, the idea of investing is simple speculation on stock price changes—it has nothing at all to do with owning a business. For individuals, it is a known fact that on average they will buy last year’s winners. An advisor can help, but you need to watch out for those advisors wanting to sell you the latest and greatest idea that their firm has come up with.
With or without an advisor, the most recent Dalbar study finds that the average mutual fund investor underperformed by almost 4% every year for the twenty years ending in 2012. This is quite a change from the twenty years ending in 1998, the last year of the great bull market when individual mutual fund investors cost themselves 10.65% a year. To put this into perspective, the average mutual fund investor who started with a 10,000 investment in John Neff’s Windsor fund and held for 20 years earning his average return of 13.7% would have ended up with $130,380. Instead the average investor ended up with $10,000 or $0 gain.
This human nature extends even to professionals. A recent academic paper written by Tim Jenkinson, Howard Jones, and Jose Vicente Martinez from the Saïd Business School, University of Oxford, put forth findings that professional consulting firms that advise institutional investors as to their fund asset allocation add zero to the bottom line. However they do provide some protection from liability, which is needed when managing pension funds.
John Neff understood this better than most, as you will see in his answer to the question: do you think active managers can outperform the S&P 500 index over extended periods?
The S&P has not been particularly difficult to beat because it is not really an index fund but, rather, a managed fund. It is run by a committee, and the committee decides which equity securities are included. Consider the case of technology stocks in the late 1990s. At one time, the tech sector grew to represent about 34 percent of the S&P 500. So, in part because of large additions of tech stocks, this very large weighting provided an opportunity for investors to get on the other side of it and take advantage of that structure in the market. Frankly, the S&P 500 Index Committee gives investors a lot of opportunities.
As you can tell from John’s answer, he was a contrarian. His favored approach was to buy only those companies whose price relative to earnings was at bargain levels. He liked to say he is playing the low P/E game of investing. He also concentrated his holdings with an average over the years of investing 40% of all the cash in just ten companies.
I was lucky enough to be managing investment accounts during the last half of John Neff’s career. I spent many of those extra work hours reading the fund’s materials and searching for tidbits of information he shared with others. He had a strong influence on my own investment philosophy; that includes believing that buying low is the single most important protector of wealth. That the markets will always give the intelligent investor an opportunity to buy low and that you should always make a decision on owning shares of companies, one by one, instead of buying the market.
I wish I could tell you that an investment philosophy comes instantaneous to each of us professional investment counselors. But it doesn’t unless you just copy, as best you can, someone else’s approach. It takes years. Many of those years are spent investigating the success and failures of other investors. It takes years of trial and error to find a process that can be implemented consistently through time. And once a process is discovered, it takes years of fine tuning to bring it together and verify that it will work as the world changes. More importantly an investment philosophy is learned and adjusted by reliving the very painful memories of past mistakes and determining if those mistakes could have been reduced.
As you know, we do believe that buying low is the single most important protector of wealth. As we search the world for bargains today we are coming up with few opportunities. Our master list of companies used to build the equity portion of our portfolios currently number 225. These are many of the largest companies in the world spanning all continents and industries. Of these, just a handful are priced at a bargain when compared to our calculation of fair value. In addition, throughout this year we have been net sellers of companies at prices we believe represent full value. The end result is a higher level of cash than we have had historically.
Cash will do a couple things for us both good and bad. For the good, cash will provide some protection against a fear driven market sell-off. If that happens, we will gladly take that opportunity to buy the bargains as they appear. On the bad side, if people decide they cannot stand sitting on the sidelines and buy at any price the averages will continue higher and our cash will be a drag on total return.
In years past, when our list of companies included very few bargains, the stock market corrected this in short order by falling quickly, or the markets just marked time until earnings caught up with valuation. We have no ability to see which, if any, of these courses will unfold in the future. Because of that, we are leaning towards the conservative approach and allowing our cash to build.
Until next time,
Kendall J. Anderson, CFA