What I Learned Growing Up In A Family Investment Office
by Daniel E. Hutner, President
Adapted from January 2012 Quarterly Report
Twenty years ago, a client referred her mother to me after she had lost more than half of her account with a broker. She had been sold publicly traded real estate partnerships, a popular investment that collapsed with the Savings and Loan Crisis in the late 1980s and the 1990 bear market. That was probably the worst result for a portfolio I’d ever seen until the early 2000s when I began to meet people who had declines in their accounts due to the collapse of the Internet and tech bubbles. And more recently, I’ve talked to a number of investors who experienced similar losses during the 2008-09 decline.
Even more troubling, I continue to see portfolios ranging from individual retail investors to large institutions that suggest that most investors have learned virtually nothing from these disastrous experiences. Even after the two worst bear markets since The Depression, portfolios today have more risk than they did before.
Ironically, at least some of this exposure is due to a misguided effort to avoid risk. Presumably to protect themselves from another stock market decline, the average investor today has actually piled into the most inherently risky alternatives – precious metals (gold and silver), commodities, junk bonds, hedge funds, small stocks, and emerging markets.
Avoiding such risks to your capital is the number one rule I learned from the professionals working in our family office, which was located on Wall Street for more than 60 years. The following are some of the most important principles they followed, many of them coming out of the experience of the early 1930s when the firm was founded. Most of the very best investors still follow these principles – Warren Buffett and Charlie Munger, of course. Leon Cooperman, Chris Davis, Glenn Greenberg, and Michael Larson are a few others that come to mind. But, today, both retail investors working with brokers and institutional investors working with consultants and/or money managers have strayed from them like never before.
1. Invest In High Quality Common Stocks For Growth
This may sound incredibly simple – and it is – but most investors aren’t doing it. Part of the problem is that it isn’t that easy to recognize a high quality common stock, especially one that will stay that way for a long time. But today the real reason investors aren’t too interested in common stocks is because the stock market just hasn’t done that well for a long time. In the same way disco has returned to the music scene, the investments that were popular during the last long flat period in the stock market, the 1970s, once again dominate portfolios. Real estate, currencies, precious metals, other commodities, foreign securities, and derivatives are all the rage.
The result is a strangely anti-business attitude as investors seek gains in nearly everything but the shares of high quality companies. For example, when I was a teenager in the 1960s, a typical million-dollar portfolio (our minimum) would have been invested solely in stocks and bonds. However, recently I reviewed a multi-million dollar portfolio with a broker that was invested almost completely in pooled vehicles (load mutual funds and ETFs). Not only were the shares of actual companies hidden from view in these fund wrappers, but the account had nearly half of its assets exposed to non-equities like commodities (agricultural, oil, basic metals, precious metals like gold and silver), currencies, bonds, and derivatives. In fact, the estimated derivative exposure from just one fund equaled the total investment in funds devoted to domestic high quality common stocks, about 14% of the account.
I wrote about another example in the July 2010 Quarterly Report. My college, like many other colleges, universities, and non-profit endowments, has gone from a traditional stock and bond portfolio in 1994 (84% stocks/6% bonds) to 93% limited partnerships (45% hedge funds/40% private equity) today. The college now has just 5% of its assets in traditional investments like stocks and bonds. These partnerships short stocks and use leverage, both risky strategies that were unheard of for an endowment when I was growing up. In addition to a monumental lack of transparency – who knows what is in these funds – the partnerships also use lockups, with 66% of the money restricted from withdrawal for at least a year. Not only will the college have difficulty exiting these investments, but in some cases the partnerships can demand additional future contributions to the fund even if it fails to perform.
Fortunately, 2011 provided some warnings for any of today’s risk-taking investors who were willing to pay attention. Hedge funds in general had their worst year since 2008 with the average fund down -3.98%. And a few hedge fund managers had spectacular declines, like John Paulson. Famous for his multi-billion dollar profits from shorting mortgage securities during the 2008-09 financial crisis, his Advantage Plus Fund was reportedly down -52% for the year.
All of this, somewhat perversely, is great news for us. As most investors dump their money into funds that buy almost anything but high quality stocks, we can scoop up the bargains that they are leaving behind.
2. Put Today’s “Hot” Tip In Historical Perspective
Exhibiting one of the greatest cases of financial amnesia in history, investors today continue to chase after what’s popular. You would think that after being burned on Internet and tech stocks, real estate, commodities, Chinese stocks, and more recently silver, that investors would have learned a lesson or two. But no. Consider the chart of the silver/gold ratio (right), which shows a peak in risk-taking behavior in 2011 that is even greater than the peaks in 1998, 2000, and 2007 (this ratio shows investors’ taste for risk increasing when they favor risky silver over more conservative gold). This chart also details the objects of investors’ affection at each risk-taking peak.
To counter this tendency to forget the past, our family office kept microfiches of every Wall Street Journal going back to the 1920s. Whenever a market event occurred, we could go back and read the headlines and financial stories about similar events in the past. It made for some pretty interesting and enlightening reading.
Even more important were the charts. My first job at the office was in the summer in my mid-teens when I would spend most of the day updating company charts by plotting data points that were calculated using a special methodology involving earnings. There were also numerous books of charts as well as some enormous charts of macroeconomic variables that covered one wall of my father’s office.
The lesson that I learned: look for clues to what’s happening today in the past and make sure to put everything in perspective by viewing current events in their historical context. To see how this might work, consider the chart of silver (right), one of today’s most popular holdings:
To understand how silver could experience a moonshot like the one shown in this chart in both 1980 and again in 2010-11, it is important to realize that the whole silver market has a value of just around $27 billion – the size of one mid-cap company. If everyone in the world wants silver, the price is going to rocket. The recent creation of ETFs that invest in silver, which for the first time opened the silver market to the average investor, have acted like a powerful afterburner. If you look at this chart, it’s pretty easy to see that 2010-11 might not be an optimum time to buy or hold silver.
By contrast, consider Warren Buffett’s purchase of $650 million of silver in 1997-98 at a price of about $5.00 an ounce, compared to $29 recently and a high in April 2011 of $50. It’s a little hard to believe, but I also have a chart of the adjusted price of silver going back to the Middle Ages, and Buffett’s purchase is right at the all-time low.
I don’t have the space to show them here, but it’s the same story with the charts of other investments that are popular today including gold, small stocks, commodities, and emerging markets. In each case, the investment that is popular with investors right now is one that has run up in price in recent years. That’s because the only way most investors judge an investment is by recent price performance, not value. So whatever has gone up is what they want, even if it’s about to collapse.
3. Buy quality when it’s cheap
Actually, you can even buy a high quality company when its price is just reasonable and do very well. But buying a high quality company when it’s ridiculously cheap is the stuff of legend. In fact, Charlie Munger has pointed out that you only need one or two such purchases in a lifetime to make an enormous amount of money. As he puts it: “Experience tends to confirm a long-held notion that being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical thing, will often dramatically improve the financial results of that lifetime.”
In 1963, the Tino DeAngelis salad oil scandal hit American Express, and within a short period the stock collapsed from a high of over $62 to $35. Buffett decided to look further than the news. He found that the losses due to the scandal were not likely to affect the business’s strong foundation – its credit card and traveler’s check operations. Seeing that there was nothing fundamentally wrong with the company, he began accumulating stock, investing $13 million (nearly one-quarter the assets of the Buffett Partnership). Over the next three years, he quintupled his money as the stock rose to $180 a share.
More recently, Munger himself took advantage of the financial crisis in 2009 to shift the investments of a small legal publishing company of which he is chairman from bonds to the depressed stocks of major banks. He bought a huge position in Wells Fargo Company, and a large position in Bank of America, along with smaller stakes in U.S. Bancorp and South Korea’s Posco. As a result, the stock of this small publisher quadrupled over the next five years, simply on the performance of its investments.
Sometimes high quality companies are even involved in what amount to turnaround situations, which offer the potential for enormous gains. Another of Warren Buffett’s most famous investments falls into this category. In the 1970s, Buffett invested $45.7 million in GEICO when it was nearly bankrupt. By 1995, the value of that holding had increased more than 50-fold based on the $2.3 billion he spent to buy in the remaining shares and take the company private. A more recent turnaround investment for Berkshire is the August purchase of $5 billion of Bank of America preferred stock, plus warrants for 700 million shares with a strike price of just $7.14 per share.
4. Don’t Take Investment Advice From Brokers
Our family firm had relationships with about 25 brokers, and we used some of their research and considered a number of them good friends. But we would never take investment advice from them. There was always a healthy distrust of their motives, since they were paid a commission for a transaction whether it worked out in our best interest or not. Our rule was to get whatever information on companies we could from the better brokers and to use them to get the best executions on trades. But we were told to never let them influence our investment decisions. (The one exception was the late Shelby Davis, a former Ambassador to Switzerland and a legendary investor in insurance companies, who also ran a brokerage firm – but that’s another story.)
Today, retail investors seem to be listening to brokers like never before, perhaps partly because they now use a wide variety of titles such as “financial adviser.” And as mentioned above, institutions like endowments have their own high-priced financial “experts,” often called managers or consultants, who function much like brokers. Ironically, only the Occupy Wall Street protestors, of all people, seem to share our old Wall Street cynicism about what brokers, and the financial industry in general, are up to. In fact, one of the first lessons that I learned in our family business was that it was our duty to protect our clients from the wide variety of threats that the financial industry presented.
One such threat, and a reason for maintaining a healthy skepticism of brokers, was described in a Forbes Intelligent Investing Panel a few years ago:
Your stock broker or investment adviser could be a straight arrow, scouring the financial world for the very best products, but it’s entirely likely they aren’t. They could just as easily push you into “house” products that help them reap better commissions. The fact is, the latter situation is far from uncommon as brokers are typically not legally bound to find the “best” products for you, merely ones that are considered “suitable.”
The column suggested that investors should work with a professional held to the “fiduciary” standard as opposed to a broker’s lower “suitability” standard described above, who has “the legal obligation to put you in only the very best products they can, and to act in your own best interest, not their own.”
Even someone held to this higher standard may not be fully qualified to guide you and your assets through all market environments. Consider the following from a recent article in London’s Financial Times, which we believe to be equally true in this country:
A report by the Chartered Financial Analyst Society of the UK condemns “financial amnesia” among institutional investors, arguing that a failure to heed the lessons of past bubbles was a key factor behind the global financial crisis... The education requirements for investment professionals in the UK do not oblige them to have “any understanding of financial history,” added Will Goodhart, chief executive of CFA UK... The British CFA programme should be reformed to include “a practical history of financial markets, designed to remind us about the effects of liquidity, psychology and regulatory failure,” the report said.
It also advised the boards of financial institutions to undertake an annual “amnesia check.” “It would be reassuring to know that once a year the board of a financial services firm had reminded itself that this time it is not different,” Mr. Goodhart said.
5. Don’t Invest In Packaged Products (Including Most Money Market Funds)
Financial innovation was a dirty word at our family firm, and new products were seen as the source of much of the evil in our world. The innovation makes it seem like investors are doing something clever and safe, but tends to hide what’s really going on.
Take portfolio insurance, the product that caused the 1987 Crash, and has since been abandoned. Sold as a new way to protect positions from a stock market decline, portfolio insurance was nothing more than the old speculative technique called stop-loss selling, or selling off a position when it reaches a certain price. However, by using stock index futures instead of the stocks themselves, portfolio insurance created a negative feedback loop with stock index arbitrage (another innovation) that produced a historic crash.
As far back as I can remember, I was taught to distrust virtually all investment products, particularly “packaged” products like open-end mutual funds, and more recently, mortgage securities and ETFs. This even included most money market mutual funds. The rule was to buy Treasury bills as a cash equivalent and only keep a small amount in a very high quality money fund like one investing only in Treasuries, usually as a sweep account for liquidity.
Over the years, I was often told by outsiders that this was extreme, but it came in handy in the fall of 2008 when the Reserve Primary Fund broke the buck (its share price fell below $1) and other money funds like the Commonfund Short Term Fund and the Prime Money Market Fund had to temporarily restrict withdrawals due to losses on supposedly safe commercial paper. Also, more recently, our policy has protected us from the risk posed by the European debt crisis. Recent estimates place exposure to European banks for the ten largest U.S. money market funds at almost 40% of total assets.
The purpose of this TBill rule was not only to make sure we never lost any money in what we thought was safe cash. We also wanted to make sure we had ample cash available in a market panic, which was the time to get the best bargains. Without funds to buy at a market bottom, you were eliminating the possibility of huge future gains.
This distrust of anything packaged by the financial industry carried over to seemingly safe mutual funds, mortgage securities, derivatives, ETFs, and basically anything that the brokers wanted to put together and sell you. Many of these products make it easy to buy overpriced popular investments that are vulnerable to sharp declines in price. They also encourage speculation since they are often easy to trade, and ironically, eliminate the possibility of large gains since their enormous number of holdings dilutes the impact of high quality companies. Keeping it simple by just buying high quality stocks and bonds was the only way to be sure you would prosper over the long term.
As one recent example, just think of how much pain could have been avoided if investors had followed this rule when it came to mortgage securities. Estimates of total investor losses from mortgage securities alone in 2008-09 are over $1 trillion. To say nothing of the stock and bond market losses, the near collapse of the global financial system, the lost economic value due to the decline in GDP during the Great Recession, and the slow growth that continues to this day during the recovery.
Unfortunately, today the financial product problem has morphed into a whole new dimension, with derivatives, especially credit default swaps, and the proliferation of ETFs presenting the gravest risks. My guess: in a number of years many of these instruments will be banned. Until then, we have to live with potentially lethal financial instruments like an ETF that allows individuals to invest in commodity futures, or open-end mutual funds that use financial futures and leverage to replicate the results of hedge funds.
Where Does That Leave Us Today?
So what does everything I learned growing up and working in our family investment firm tell us about the financial markets today? First, it says that the markets are as treacherous as ever, and probably more so, since investors are borderline bonkers right now and many of the old protections (like the uptick rule) have been whittled away. Based on the principles I learned, we are probably at an all-time high in foolish and risky investor behavior. That’s hard to believe after 2000-01 and 2008-09, but the silver/gold ratio and the flood of money into risky assets suggest that it is true.
Second, it means that there are huge opportunities for us “old-fashioned” investors who simply buy stocks and bonds. This hasn’t exactly been lost on some of the most skillful investors I know, who have been loading up on high quality companies over the past year. But it is a novel concept for the public, which for the sixth year in a row has taken money out of domestic equity mutual funds – another $98.8 billion in withdrawals in 2011, the most since 2008.
Just like the 1970s, when Buffett and my father and other people who influenced me like Charles Allmon (founder of Growth Stock Outlook) were buying up shares in underpriced but high quality companies, opportunities today abound. As one analyst says, “this group of [25 very safe, high quality] companies offers a three-pronged opportunity for above-average future total returns at below-average risk. We expect that each company will benefit in the future from a potential expansion in their PE ratios coupled with future earnings growth and finally followed by dividend increases offering a return kicker.” Perhaps that explains why Berkshire Hathaway spent $23.9 billion on new stock and private company purchases in the third quarter of 2011 alone, the most in 15 years.
Daniel E. Hutner, President
NOTE: The information provided in this report should not be considered a recommendation to purchase or sell any particular security. Graphs and charts are provided only to provide historical information. Nothing contained herein shall be relied upon as a promise or representation whether as to past or future performance. This report has been edited slightly from its original form.