Big changes coming

While most of the financial media focuses on the price of oil and what it will do to consumer spending in the next few months, a tectonic shift in technology is underway that will have enormous consequences over the next several years. Investors who are myopically focused on the short-term, speculative, sector-timing or cycle-timing schemes that dominate much of what passes for "investment" these days seem to be blind to this major development and will only notice it after it is too close to ignore.

We have written in previous posts about the impact that the ability to move exponentially larger amounts of data -- including video data -- will have in the next several years, including fundamental changes in computing and television.

Now, Sony (a major television manufacturer) has announced an agreement with cable companies by which new televisions can have internal hardware and software that enable features that currently require an external set-top box -- including "two-way" features. In other words, "smart" features which currently are an option for those who choose to purchase additional services are likely to become standard features in future televisions.

But this is only the beginning of a wave of changes which will be enabled by the rapidly expanding ability to easily send and receive huge amounts of data, including video data, over the internet.

As George Gilder foresaw in Life After Television in the early 1990s: "What is driving the 'telefuture' is not any convergence of films and TVs, consumer electronics and publishing, computers and games. What is driving the change is the onrush of computer technology invading and conquering all these domains. The computer industry is converging with the television in the same sense that the automobile converged with the horse [. . .]".

The ramifications of this shift will not be limited to how the average individual consumes video entertainment (although that will also be significant). It will enable valuable new possibilities in medicine, in business consulting, in the creation of wider markets for all kinds of specialized goods and services, in education, in defense, in transportation, in logistics -- in short, it could conceivably impact virtually every aspect of life.

Small news items largely ignored by the headlines today continue to indicate that this major shift will indeed take place. Investors who are pursuing longer-term fields of growth, rather than calling the next short-term move of this sector or that sector, should take note of these indicators.


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For later posts on this same subject, see also:

• "Big changes coming, part II" 07/08/2008.
  

• "The Unstoppable Wave" 01/12/2009.
  

• "Clayton Christensen, disruptive technology, and your portfolio recovery plan" 02/04/2009.
  

• "Revisiting the 'New Economy'" 05/06/2009.

• "Ladies & Gentlemen, Start your bandwidth engines!" 06/26/2009.

• "Dangerous media distractions" 07/07/2009.

• "The Unstoppable Wave: Revisited" 12/22/2009.

• "Was the decade lost?" 01/14/2010.

• "Exaflood update" 06/01/2010.

• "Have you heard of this company? HITT" 07/06/2010.

• "Have you heard of this company? IIVI" 08/05/2010.

• "What battles of the tech titans tell us about investment theory" 09/08/2010.

• "Another wake-up call" 11/29/2010.

• "Have you heard of this company? EZCH" 12/09/2010.

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Memorial Day May 26, 2008

On Memorial Day we honor those who solemnly swore "to support and defend the Constitution of the United States against all enemies, foreign and domestic."

It is also fitting to consider that the Constitution they have defended and laid down their lives to protect is the source of all the freedoms we enjoy in America, guaranteeing the right of the people to be secure in their persons and property against seizure, a right upon which all the creation of value and wealth and security that we enjoy is founded. America has the oldest existing Constitution in the world, and those of us who enjoy its freedoms are indebted to those who have defended it through the centuries even to the extent of the sacrifice of their own lives, and who continue to do so today.

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The active vs. passive debate

In our previous post, we pointed out features of mutual funds which can act as an obstacle to following the Taylor Frigon dictum of building future wealth upon a foundation of the ownership of successful business enterprises benefiting from capable and dynamic management operating in a future field for fertile growth, and owning them over a long period of years.

This discussion naturally brings up the debate over indexing or what has been called "passive management," because a large number of investors who do realize the drawbacks of mutual funds use those drawbacks as arguments in favor of investing in index funds or other vehicles designed to capture a market or portion of a market.

At the very outset of the discussion, we should note that using the drawbacks of mutual funds as an argument for passive management is illogical, because (as we have argued) the drawbacks to mutual funds stem from the ways in which they impede the investor's ability to own exceptional companies for a long period of years. Running from a vehicle that impedes such ownership to a vehicle built on the outright rejection of the concept of ownership of exceptional companies is not a logical move.

Many index fund backers and other passive management supporters do not have the background in selecting companies which would enable them to see that the problems with mutual funds are primarily related to the extent to which they impede ownership of exceptional companies for long periods of years.

We explained previously that advocates of passive management (such as Vanguard founder John Bogle, pictured above) argue for the ownership of markets rather than the ownership of businesses, in posts such as this one and in our commentary entitled "The Emperor's New Index Fund."

Advocates of passive management often adopt a very condescending attitude towards the very concept of trying to select superior companies, arguing that the issue has been settled beyond doubt. An example of such condescension is found in this reproduction of the opening arguments in an active vs. passive debate which took place in 1995. It is a good example of those arguments, touching on most of the main points used by advocates of passive investing.

The author of that piece, Rex Sinquefield, not only argues that academia has proven beyond any shadow of doubt that belief in active management is simply "no longer a credible position," but also goes so far as to co-opt the economic triumph of free-market capitalism over central planning as an argument for passive management! He does so by implying that active management is somehow a rejection of the idea that "markets work" and that anyone who believes -- along with Adam Smith and Friedrich Hayek -- that markets do work should ipso facto be an advocate of passive investment.

In fact, he jokes that the only people who still disagree with Smith and Hayek are "the North Koreans, the Cubans, and the active managers."

But, which is more aligned with the principles of free-market capitalism: the idea of allocating capital to successful business enterprises, or the idea of allocating capital indiscriminately to all businesses in a blanket fashion? As we have argued elsewhere, in free-market societies, most people do not allocate their own "human capital" by indiscriminately working for any business in any industry as if one is just as good as another (Sinquefield himself did not do so). Why would they allocate their financial capital that way?

Furthermore, opponents of active management often describe active management as being dependent upon finding bits of information before the market has time to react to those bits of information, trading on inefficiently-distributed information before the market has time to adjust. While this kind of behavior is what many think of as "investing," we have argued that this picture of investing is not the whole picture (although Wall Street and the financial media tend to reinforce that point of view).

The classic investment philosophy we have described in previous posts, and that was practiced in previous decades by Dick Taylor and Thomas Rowe Price, was not based on any such attempts to "dip and dart, pick stocks and time markets" as Sinquefield describes. It is not based on an attempt to exploit temporary inefficiencies or unknown information, but rather upon the long-term superiority of business fundamentals to market-timing schemes. It also accords very well with the principles of Adam Smith and Friedrich Hayek.

As for the very common assertions made by advocates of passive management that "all studies to date" show no evidence that any strategy can be better than owning markets, consider any list of the wealthiest Americans published this year or in previous years going back for about a century, and ask yourself how those individuals became that wealthy. Did any of them achieve their great wealth through a system advocated by promoters of passive investing, or was it rather through a process that more closely resembles "the ownership of successful business enterprises that continued to grow and prosper over a long period of years"?

In the same 1973 tract in which he explained his Growth Stock Theory of Investing, Mr. Price also published the results of his portfolio from 1934 through 1972. Over the course of those forty-two years, the increase in market value of his portfolio was at a compound annual growth rate (CAGR) of 11.9% per year, versus the Dow Jones Industrial Average's CAGR of 6.2% per year. The dividend increase of the Dow over the same period was 5.4%, versus 9.4% for Mr. Price's portfolio. Advocates of passive management dismiss any out-performance by some managers as "nothing more than one would expect by chance" (to use the phrase of Mr. Sinquefield). However, it is difficult to argue that the record Mr. Price achieved following his method of selecting well-run businesses in front of fertile fields of growth was a "chance" anomaly that persisted for a period of over four decades!

Finally, it must be noted that index or ETF investing in practice often boils down to owning this slice of the market and then that slice of the market and thus "market-timing" in the very way that Sinquefield eschews, dipping and darting and picking and timing but doing so by picking "sectors" or "capitalizations" or other large groupings rather than individual stocks.

Investors today will encounter many arguments that present the superiority of passive management as an unassailable fact. However, we would caution investors not to be too easily dissuaded from the sound principle of ownership of businesses.

For later posts dealing with this same topic, see also:

• "The zero-sum connection" 06/02/2008.

• "Beautiful growth companies, part III" 05/13/2009.
  

• "If Rip Van Winkle took a one-year nap before September 15, 2008" 09/14/2009.

• "S&P takes aim at active management" 10/07/2009.

• "The best defense is a good offense!" 12/03/2009.

• "Composite performance through 12/31/2009" 01/11/2010.

• "Free markets, free enterprise, Friedrich Hayek, and active allocation of investment capital" 07/13/2010.

• "Does a rising tide really lift all boats?" 07/20/2010.

• "The dance of the hippos" 08/10/2010.

• "What battles of the tech titans tell us about investment theory" 09/08/2010.

• "The growth theory of investment works" 01/14/2011.

• "Don't confuse free enterprise with a questionable theory about securities markets" 01/19/2011.

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Some drawbacks of mutual funds

We've written in numerous previous posts about our conviction that "ownership of successful business enterprises which continued to grow and prosper over a long period of years" should form the bedrock foundation of capital investments for most investors. While there are many other important investment strategies which should be added in certain situations (such as a strategy which will yield current income, or a strategy which gains exposure to earlier-stage enterprises), these should still be built upon the foundation of the ownership of successful business enterprises.

We have also shared some information about obstacles investors face even if they understand and agree with this philosophy. Principal among these obstacles is the intermediary system of "wealth management" that has developed over the past few decades, which separates investors from those who actually evaluate and select those individual businesses (see, for example, this previous post).

However, there is another major obstacle to the investor's ability to build a foundation on the ownership of successful businesses over a long period of years, one that is so widespread and so basic to the modern investment landscape that most investors would be shocked to learn that it has such drawbacks: the mutual fund.

In 1980 there were about $135 billion in assets in all the mutual fund investments in the United States -- today there are more than $11.7 trillion (ICI). Mutual funds are very scalable, and with the proliferation of intermediary "wealth managers" and "financial advisors" who do not actually manage money but instead "outsource" the management to others, the assets committed to mutual funds grew significantly.

But the mutual fund model has many drawbacks, some of which are not fully understood even by very wealthy investors.

One drawback is that the individual investor no longer owns the securities (such as the shares of common stock) in his own account, but rather owns shares of the mutual fund, as depicted in the diagram above. An open-ended investment company (the more precise term for a mutual fund) is a pooled vehicle, in which the assets of the investors are pooled, and the pool owns the shares rather than the individual investor, who owns shares in the pool instead. This serves to distance the investor from the ownership, and brings about a variety of other side-effects which impede the investor's ability to build a foundation of ownership for "a long period of years."

One significant negative side-effect is the tax drawbacks to the mutual fund's pooled ownership structure. We discuss some details of this tax drawback in a commentary we published called "Separate Portfolio Advantages" which is available on-line. The tax drawbacks to mutual funds can be extremely damaging to wealthier investors, who are typically taxed at higher rates and have more exposure to a wider variety of taxes.

Another significant drawback to mutual funds is that they tend in many cases to rely upon an investment process that is based on the performance of markets rather than the performance of businesses, which is a crucial distinction. The reason for this tendency is again related to their pooled nature and to their size, as we detailed in this previous post. Basing your financial future on an ability to call the next move in a market (or, in the case of many mutual funds, of one sector of the market versus another sector of the market) is in many ways the opposite of basing your financial future on ownership of successful businesses for a long period of years.

We have also discussed the problems of "style drift" and "deworsification," both of which are also obstacles to the investor and both of which are tendencies that the mutual fund structure can exhibit, especially as a mutual fund's pool of assets becomes larger and larger.

In short, although there are mutual funds which are the exception to the rule and there certainly is a place for them with investors who are too small to adequately own individual companies outright, there are significant drawbacks associated with mutual funds. Many investors are not aware of these, although they should be in light of the popularity of mutual funds as an investment vehicle. Most importantly from our perspective are the ways in which these drawbacks tend to inhibit the average investor from pursuing what we know to be a successful formula for the creation of long-term wealth: "the ownership of successful business enterprises [. . .] over a long period of years."

For later posts dealing with this same subject, see also:

• "The active vs. passive debate" 05/22/2008.
  

• "The zero-sum connection" 06/02/2008.
  

• "The intermediary trap and the current bear market" 11/03/2008.

• "More evidence of the dangers of modern-day 'wealth management'" 11/05/2008.

• "Your portfolio recovery plan" 11/10/2008.
  

• "The bonfire of the intermediaries" 01/29/2009.

• "If portfolios were parachutes" 03/09/2009.
  

• "The same thought process for 30+ years" 03/31/2009.
  

• "Back to the old drawing board!" 04/29/2009.
  

• "Invest like Mr. Howell" 05/18/2009.

• "The business focus of the great 20th-century investors" 08/20/2009.
  

• "The ETF industry and their promise of easily adding alpha to all" 09/04/2009.
  

• "S&P takes aim at active management" 10/07/2009.

• "Some lessons from 2009" 12/28/2009.

• "What a farmers' market can teach us about money management" 01/18/2010.

• "The financial services timeline, 1977 to present, and what it means to you" 03/18/2010.

• "Free markets, free enterprise, Friedrich Hayek, and active allocation of investment capital" 07/13/2010.

• "The dance of the hippos" 08/10/2010.

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Grading on a curve in the equity ratings business? ? ?

Wednesday, a major national broker-dealer announced its intention to change its equity research ratings system, starting on June 2 of this year.

The amazing thing about this new system is that it mandates a distribution of ratings within each "coverage cluster" (defined as a single analyst or multiple analysts sharing a common region, sector, or classification). Specifically, the guidelines will mandate that at least 20% of the coverage cluster will be ranked "underperform."

While there may be a perception among the investing public that analysts are reluctant to give negative ratings to the equities of covered companies, this new direction by a large firm closely resembles "grading on a curve." It basically says that in every classroom, the top students (up to a mandated limit) will get high grades, and the bottom students will get low grades.

Consumers of such research must therefore realize that a highly rated company is not highly rated in absolute terms but rather in relation to the other companies in a "coverage cluster," and likewise with negatively-rated companies.

The head of research stated, "The rationale for imposing distribution limits is simple: we want to ensure that our analyst distributions correlate more closely with historical return statistics of stocks." But this is ludicrous! By the very definitions of their ratings, the analysts are assessing the future performance potential of the company in question. They should not be forced to conform their prediction of future performance to a "historical" distribution of some group of companies in the past!

This is like saying that candidates for leadership positions will be judged on their own merits to a certain degree, but that the leadership positions must also be filled in a way that reflects the demographic percentages of the general populace. Why an investment firm would decide to do that with stock ratings is astounding.

It is even more astounding when investors consider the dramatically reduced analyst coverage at many big firms in the wake of their settlement with regulators in 2003 (in which three sell-side firms were accused of issuing fraudulent research reports, and seven others with issuing research reports which "contained exaggerated or unwarranted claims"). If stocks are now being rated based on their relative positions within a "coverage cluster," investors should be aware that many companies they might assume would be in that coverage cluster are not even covered, which further calls into question the concept of grading on a curve.

We have recently shared some of the guidelines that many decades of investment experience have shown to be valid guidelines for selecting businesses with superior prospects for capital investment. These guidelines are not relative guidelines but are based upon crucial, objective standards such as return on invested capital and compound annual earnings growth. We would advise investors that grading on a curve is a bad practice when it comes to deploying their own capital.


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