Portfolio manager’s Letter September 2000
Ok, I admit I worry too much. This market makes me nervous. I know this is foolish, this time it is different, only the chronically depressed are not fully committed to equities. But I can not help myself, every time I start to feel better I read something about Japanese banks, or M2 falling, or the Inversion of the yield curve; and I get nervous again.
One of those moments of fundamental discomfort came last week after a potential client asked me to review one of her mutual fund accounts. The person making the request was a Widow with two children under the age of twelve. The account in question was large (well into six figures). It was with a fund family of a large American life Insurance company. It may well be that the funds in the account represent the proceeds of a life insurance policy on the Woman’s Husband who died of Cancer. The account was divided into three funds managed by the life insurance Company.
On the surface it does not sound too bad, even though ten years ago no one would have suggested that a portfolio of pure growth funds would have been the proper mix for a widow with young children (Times change.) At least there is no mention of aggressive growth, or suggestion of heavy speculation in names of the funds listed. The use of the Insurance Company’s name for the family would suggest conservative management to most people, and the three funds covering different sectors of the market gives the impression of diversification.
But a visit to the Morningstar WEB site reveals a different picture. The large cap growth funds top four stocks are Microsoft, Intel, General Electric, and Cisco. 17% of the funds assets are invested in 4 stocks with an Average PE of 81. 23, of the top 25 positions (65% of total assets) the average PE was 77.9. The other two stocks had no earnings at all. This is what the wonderful world of mutual fund people are selling to widows these days.
The financial industries Fund should be conservative right? This is field where you would expect to find lower PE’s, but the average P. E. of the top ten holdings is 35. Still 35 is a whole lot better that 77.9 yet this is still an aggressive fund and loaded with momentum stocks. To my simple mind even this is a questionable selection for this particular client. She is young and is looking to this money to provide for retirement income. With a long-term horizon why should she take on high-risk securities in order in enhance short-term, prospects?
But the best is yet to come, The Small Cap Growth fund is a bomb waiting to go off. Ten of the top 25 positions have no earnings at all, for the fifteen companies that do have earnings the average PE is 102.47. Except for two energy companies the top twenty-five positions are all either tech, biotech or communications. The top ten:
So what on the surface appears to be a relatively conservative, diversified portfolio turns out to be not conservative at all, but a highly speculative collection of Tech and momentum plays. There is very little real diversification; every thing is a momentum stock, in a real bear market all the momentum stocks go off the cliff at the same time. There are no defensive stocks, no Value stocks absolutely nothing in any of the three funds that is a suitable holding for the individual who owns this portfolio.
It is possible, of coarse, that we will have a soft landing and that the tech stocks will come back and lead market higher, but for how much longer? The present economic expansion is already the longest in history. The PE ratios are higher that the Japanese market in 1989 and those were higher than in the US in 1973 or 1929. Everyday that the market goes up is another day closer to death.
The potential reward from chasing stocks like those in the Funds of this life Insurance Company gets less and less, and at the same time their level of risk is moving from large to enormous. How can this be, these investment managers are smart people (at least they get paid like they are smart), why would the put theirs customers money at risk?
Put yourself in the position of someone running money in this crazy market. A investment manager is judged based on his record for the last 12 months or even worse – the last 3 months. Today, money has feet, if a fund manager under-performs, money walks out the door. The majority of funds had a net outflow for the first half of year 2000. Only the funds that were buying tech and momentum stocks had cash coming in. My guess is that many of the managers buying these stocks are smart enough to know that the values are crazy, but they also know that their job and their seven figure salaries are based on short-term performance.
They have a choice; they can buy value and maybe be right in the long run. Or they can buy momentum and remain employed. If you are a fund manager in this market and you are taking a long-term view, the money is flowing out; and you know that if it keeps flowing out you will be out of a job. This creates a classic conflict of interest between Fund Manager and the Fund Customer.
The managers interest is served buy short-term performance whereas the customer interest is, or at least should, be long term. This is a situation that in the past has generated bad results for everyone.
Maybe I am crazy, or maybe just old and crotchety, but when I see this Managerial behavior and the portfolios that result it scares me. In this market an open-ended mutual fund is a very poor vehicle for managing money. Too much money, and the flows are always going the wrong way (money flows in when stock prices are high, but when the prices are attractive the money is gone.
Today, Mutual Funds are huge; the assets they have under management represent a very large percentage of this nation’s wealth. Could their mistakes lead our economy over the edge of the abyss? Probably not, but the broader implications are all bad.
I do not think that this is isolated behavior. I think that portfolios like the ones described above are now the rule, not the exception.
I do not think that the people that own the mutual funds have any idea the kind of risk that is staring them in the face. You can say that the customer should be responsible for knowing what is in the funds they hold, but the reason that a person buys a mutual fund is that they do not feel comfortable picking stocks on their own. They buy a mutual fund because they want “Professional management” but what they are getting now is a trip to Las Vegas.
Too many years without a serious in the stock correction has created complacency that could turn out to be very expensive. Investors expect the Fed to bailout the stock market if anything bad happens. For twenty years all dips have been buying opportunities. But nowhere in its enabling legislation is there a guarantee the fed will always have the ability to save us from our own ignorance.
The Small cap growth fund listed above contains stocks that can, in a recession. lose substantially all their value and never recover.
Even the larger funds above could face problems in a bad market. They have very low cash levels. Financial Industries has .9% of its assets in cash. Large Cap Growth has .3%. If the market turns quickly as it did in 1987 Investors will start withdrawing cash fast. With no cash reserve the funds will be in the position of having to dump stocks into a falling market just to cover redemptions.
They will have to sell their liquid positions (The Good stuff) on the way down to cover redemptions, and then face a long period In which they do not have new money flowing in and therefore have no money to buy the stocks that are leading the market back up.
This is a dangerous market. It is dangerous for the manager, his mutual fund the customer, and for the Nation’s economy. All the money flowing into tech stocks is nervous money with light feet, and as soon as the momentum breaks, everybody is going to try to get out the door at the same time, and we all know what happened in 1987. If the market does break badly it will be a very long and slow climb back up the hill for these and many other mutual funds.
Beyond the negative implications for the nation’s economy, The long-term impact of a mutual fund catastrophe on Berkshire Hathaway are likely to be very positive. As the money flows out of the mutual funds, the elephants will come running out of the jungle and Warren Buffett is likely to be the only one standing there with any bullets left.
What would be the impact on Berkshire Hathaway of a major market melt down? While it might suffer with the market in the short run, the long-term result would be substantially increase its annual return. Its return will go up as the price of prospective investment go down. Any attempt to quantify this increase would be strictly as guess. My guess is that the increase could be as high as 5% annually.