The koi pond analogy of investing

We have often explained the foundation of the growth stock theory of investing using the quotation from Thomas Rowe Price in which he advises investors to search for "dynamic, capable management operating in a fertile field of future growth."

We have previously explained that one way of defining "fertile fields of future growth" is through the concept of paradigm shifts (closely related to Clayton Christensen's concept of "disruptive innovation" or Joseph Schumpeter's concept of "creative destruction").

We believe it is very important that investors devote some time to actually assessing the potential "fields of growth" for every single company in which they invest capital, or in which they are considering investment of capital.

In practice, this is actually much easier said than done. Determining the monetary value of an addressable market is not at all an exact science, and depends significantly on whether the market will change in the future by growing larger or becoming smaller. Nevertheless, without falling into the error of believing they can precisely assess the size of the total addressable market to the penny year by year, investors should still devote some mental energy to assessing the total addressable market and evaluating factors that could cause it to grow or shrink over time.

An analogy for this assessment might be to think of the company's total addressable market as a "koi pond," in which the pond is the addressable market and the koi (Japanese carp) is the company. The key point of the analogy is the relationship between the two -- the size of the fish to the size of the pond. If you want to grow larger koi, you need to provide the fish with a larger and deeper pond. The same is true for a business enterprise.

Using the koi pond analogy can help the investor envision the size of the company in relation to the size of the market it is addressing. If the market is small, then even if the company eliminates all competition, that company's growth is limited by the small size of the pond. As growth investors, we are not looking for fish that have limited room to grow (small fish in small ponds, or large fish in large ponds that do not support further growth).

A better scenario is one in which the pond is large and contains small fish with plenty of room to grow (particularly if you can identify the fish that you think will be able to outswim and outgrow the others). Even better is to identify a pond that is getting ready to burst out of its boundaries because of some paradigm shift, or one that has already begun to burst out and turn into a lake of enormous size!

A company that has come to dominate a market, with no indication that the market will grow in the future, does not meet our definition of a growth company. This is the case whether it is alone in that market or shares it with a few others. That company might be a source of ongoing dividends, but it will not likely be a source of future growth. We discussed an example of this in "The importance of a proper sell discipline."

Investors should definitely be looking for "koi ponds" that are either very large in relationship to the existing market participants, or that are currently expanding rapidly due to "paradigm shifts" or "disruptive innovations" discussed earlier. Using current representative revenues, and some expected rate of growth in those markets, investors can approximate how large that market may ultimately become.

This type of projection of a market is definitely an art and not a science, and it bears repeating the caution that exactitude is not achievable and that continued monitoring to see what actually develops will be necessary. However, if you have done some preliminary estimating, you may be better equipped to identify early signs of changes.

Also, it is important to realize that companies that are successful in filling up one market will often expand into a different market, if there is little likelihood of their core market expanding further. This scenario is different than the "bursting out" situation described earlier, because it does not involve the growth of the existing business but rather a recognition that the existing pond will not grow further, and so other completely different business lines must be found. Investors should always maintain healthy skepticism of such forays into new "koi ponds," because the environment may well be different in those new markets and present challenges to management.

In any case, the koi pond analogy can help investors to understand the critical concept of "fertile fields of growth," and serve as a mental image to help assess the growth potential of the businesses in which they invest capital.

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The business focus of the great 20th century investors

We are occasionally asked what books we would recommend to those who wish to become better investors.

In general, we would argue that many if not most books written about "investing" that you find in the bookstore and library shelves are of little real value to the investor, and can in fact be downright harmful.

Because we view investing as the art and science of matching capital with business innovation(as we discuss here and here), we would advise investors to look for good books about business innovation rather than "investment" books per se.

However, we would also advise that investors become familiar with the thinking of some of the more successful investors from the twentieth century, particularly those who formed their investment philosophy prior to 1974. As we have explained in detail in previous posts such as "The poison of 1974" and "Beware of the witch doctors of modern finance," 1974 was a watershed year in which the entire focus of the investment world shifted towards the "modern portfolio theory" which dominates investing today.

As a result of that tectonic shift, the voices of the giants of twentieth-century investing can sound to the reader of today as if they are coming from another planet. The past year has exposed the flaws of the "modern" theories, however, and should serve as a wake-up call to the investment community to go back and examine what they threw away when they embraced the academic models and hypotheses.

The investment philosophies of the great twentieth-century investors differ from one another, of course, just as different styles of martial arts differ from one another in their approach to self-defense. However, we would argue that in spite of their differences, the styles of those pre-1974 investors had more in common with one another than with much of what is practiced today, because they were focused on ownership of businesses. The particular things that they looked for in a business may have differed, but they were united in having a business focus.

In contrast, those who espouse modern portfolio theory believe one can utilize algorithms to magically diversify away risk and maximize returns. Instead of focusing on individual businesses their strategy is more concerned with gaining exposure to various asset classes, "style" categories, geographies and capitalization levels, typically using mutual funds or ETFs. While it could be argued that these mutual funds or ETFs at least own securities issued by businesses, we have demonstrated that the very structure of the large asset-management pools (such as mutual funds) tends to force their managers towards a shorter-term approach based on the movement of the "market price prospects" of a stock rather than a longer-term approach that is based on the business prospects of a company (see the discussion in "The further you are from owning individual companies," published in November, 2007).

Thus, we would argue that the investment approach taken by great twentieth-century investors such as as Philip Fisher (1907 - 2004), John Templeton (1912 - 2008), Philip Carret (1896 - 1998) and Thomas Rowe Price (1898 - 1983) are actually more similar to one another than they are to much of what takes place in the big mutual fund companies (some of which even bear their names).

The writings and thoughts of these men can serve as an antidote to much of what the financial world and media typically focus on from day to day. Consider these selections for starters:

  • "Fear of having too many eggs in one basket has caused them [investors] to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all. It never seems to occur to them, much less to their advisors, that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification" (Philip Fisher, Common Stocks and Uncommon Profits, 129).
That observation, published in 1957, is a stinging indictment of much of the "deworsification" that caused investors so much pain in 2008 (further discussion of the impact that had during 2008 is available here and here).
  • "Achieving a superior record takes much study and work, and is a lot harder than most people think" (John Templeton, Time-tested Maxims #2). This thought is closely related to the following quotation from Philip Carret.
  • "More fortunes are made by sitting on good securities for years at a time than by active trading" (Philip Carret, cited in Glassman's "Learning from the Long Men").
This last maxim is strikingly similar to a belief held by Thomas Rowe Price, with whom the late Richard Taylor managed money and from whom the investment discipline at Taylor Frigon is directly descended. As we have noted several times previously, he told investors:
  • "Most of the big fortunes of the country were made by men retaining ownership of successful business enterprises which continued to grow and prosper over a long period of years" (Thomas Rowe Price, "A Successful Investment Philosophy based on the Growth Stock Theory of Investing," 1973).
We would advise investors who are not familiar with the successful "pre-1974" investors to take the time to become familiar with them, and most importantly to rediscover the business focus that they had and which much of the investment world has lost.

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Former analyst predicts "Nasty correction or years of treading water"

Former Merrill Lynch analyst Henry Blodgett recently wrote an article entitled "Is that finally it for the sucker's rally?"

His article makes use of some interesting charts, including this one from, which shows the recovery track of four legendary bear markets, including the most recent, the 2000-2002, the 1973-74, and the Great Depression.

Observing that each of the other three bear markets prior to this one went back and tested their low (the Great Depression not only tested its low but broke right through it to plumb new depths), Blodgett calls the 44.8% run-up in the S&P since March (blue line) a "sucker's rally."

While admitting that further gains from here are possible, he declares: "But it doesn't seem likely. More likely, we're in for another nasty correction or years of treading water, as the v-shaped recovery proves less vigorous than the market now thinks it will be."

Blodgett's article provides some insights into the reason he comes up with this gloomy prediction, primary among them being his clear acceptance of demand-side arguments for what drives the economy. His main argument is that the consumer will not be increasing his spending, and as everyone knows, the consumer "still accounts for a staggering 70% of the economy."

We have explained previously the problems with the Keynesian belief that the consumption, or demand, side of the equation drives economic activity -- most directly in 2007's "Happy Thanksgiving to All" post. It is a view that is so widespread and so often-repeated by the financial media that even insightful and experienced market observers such as Henry Blodgett can be sucked into buying it.

We believe the evidence that producers are the actual drivers of the economy, rather than consumers, is far more compelling. Investors should be wary every time they hear a prognostication based on the consumer being "responsible for 70% or 80% of the economy."

More importantly, we believe that comparisons of this market recovery to others from history are of limited value, due to some significant differences in the circumstances surrounding this particular bear market. We have provided extensive analysis which argues that the most recent bear market was brought about by a rare financial panic, very different from the conditions behind the 2000-2002 and 1973-1974 bear markets (see for example here and here). Based on this understanding, it is not surprising that the current market recovery has been faster and steeper than the recoveries that followed 1974 or 2002.

Most importantly, while we do not necessarily agree with Mr. Blodgett's demand-side arguments, or with his pessimistic conclusion, we would point out that we have also sounded a note of caution for investors going forward, based on the likelihood of both higher taxes and greater government intrusion into business activities in years ahead.

Most tellingly, in a post from this February entitled "Return of the 1970s, part 2," we said that:

"It is quite possible that the markets will snap upward with startling velocity when the current banking crisis is resolved. We believe that mark-to-market accounting continues to play a major role in holding the financial system hostage, as we have discussed several times previously (for instance here, here, and here). Repeal or even temporary suspension of the rule may well serve to ignite such a rally." That prediction was borne out less than three weeks later, when mark-to-market accounting was modified and the market began the rally depicted in the chart above.

However, in that same post, we noted that the 1970s demonstrated that just owning "the market" or the "Nifty Fifty" (an idea that held sway in the 1960s) did not work in all economic environments. While there was an impressive rebound after the 1973-1974 bear market, the rest of the decade was a clear example of the lesson that "during more economically challenging periods, where growth is harder to come by, the same larger companies can generally tread water, and selection of well-run companies involved in some kind of business paradigm shift can become much more important."

It is very possible that Mr. Blodgett's prediction of "treading water" may come true for the overall market, particularly if some of the anti-business mistakes of the 1970s -- such as price controls, wage controls, high taxes, and an inflationary monetary policy -- are repeated in years ahead. In such an environment, many companies may just bob along within a fairly stagnant economy, which is why that February blog post emphasized the critical importance of looking for those rare companies positioned in front of innovative growth fields.

While we do not agree that the recent run-up was just a "sucker's rally" (and we would caution that some pullbacks or "backing and filling" is normal and healthy after a strong move upwards), we do believe that investors should be concerned about a period in which the broad market may go back to "treading water" -- not necessarily right away, but after the market has finally recovered from its irrational panic.

Our advice for those concerned about such a scenario is to be sure to own growth companies in the equity portion of your portfolio, and not "the entire market."

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Caution: Fed oversteering ahead

The Federal Reserve continues to signal its intention to maintain a highly accommodative stance of "exceptionally low levels of the federal funds rate for an extended period," while acknowledging that "the prices of energy and other commodities have risen of late" (see full FOMC statement here).

The editors of the opinion pages of the Wall Street Journal voiced their concern over the Fed's continued extreme accommodation in a piece today entitled "No Exit: the Fed keeps the accelerator floored." The editors advised, "It's a lot safer to slow down gradually than have to screech to a halt to avoid another asset bubble."

Similarly, economist Larry Kudlow today penned a blog post entitled "Have we seen this Fed movie before?" In it, he asks, "Is the Fed repeating the very same easy-money mistake it made between 2002 and 2005, when it totally bubbled-up and inflated housing, energy, and financial markets, all of which led to a 6 percent inflation rate down the road? Of course, all of that also led to a very deep recession."

The problem both articles are addressing is a very grave problem, and one we have addressed before. It is the modern phenomenon that we call "Fed oversteering," which we addressed last month in a post entitled "The Fed's oversteering and the wreckage of the past decade" and one we would recommend re-reading this week.

The Fed initiated their current near-zero funds rate policy in the depths of the financial panic that was largely caused by the deflation of the last Fed-induced bubble. The very real danger is that the Fed's excessively easy stance will lead to another bubble, that the Fed will eventually move to choke off -- possibly wiping out valid businesses in the process (just as valid businesses were wiped out -- or at best dealt a staggering blow -- when the Fed tightened severely in response to the dot-com bubble in 2000).

This kind of volatile Fed policy is something that businesses -- and investors in those businesses -- should not have to deal with. However, it appears to be part of the landscape for the foreseeable future.

Investors can print out the above "caution" sign and pin it above their desks in order to remind themselves to be alert for the inevitable repercussions of the Fed's oversteering.

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What "Sell in May / go away" has to do with the "persistent delusion"

We recently published "A Conversation with Gerry Frigon" in which longtime portfolio manager Gerry Frigon made the observation that Wall Street, reinforced by the twenty-four hour financial media cycle, has cultivated the image of knowing better, of being able to time this trend or that trend.

"Built into the system," he said, "is a sense of inadequacy in the investor," which serves to make the average person feel dependent upon the professionals, who "reinforce the delusion that they know something that someone else doesn't."

One old Wall Street expression that the financial media trots out every spring is the dictum, "Sell in May and go away," which supposedly describes the behavior of the "big Wall Street traders" and other "players" who know more than you, the poor outsider hungry for a few crumbs of smart money knowledge.

Every year in May, studies appear which analyze the average performance of the equity markets in the summer and fall months of June through October, versus their performance in the other months of the year.

Even if these studies actually turn up some seasonal patterns in stock market behavior, it does not stand to reason that investors should actually build their own investment strategy on an attempt to time these cycles.

For one thing, just because a majority of those months throughout history have been negative, or less positive than other months of the year, this fact has virtually no bearing on what those months will look like this year. This year, for example, the broad equity market as measured by the S&P 500 index rose 0.20% in June, 7.14% in July, and 1.99% in August through August 10, even with the pullback of the past few days.

Investors who sold anytime during May would have missed all that investment growth (possibly more, if they owned companies that performed better than the broad market).

Furthermore, depending on when in May they sold, they missed some gains in that month as well -- the S&P 500 index went up 5.31% in May of 2009 as well. The chart above depicts the axiom-defying movement of the index so far this year (with dotted lines showing the performance above its level at the end of May and also the beginning of May).

The bigger issue, however, is that investors should free themselves from the illusion that some Wall Street insiders or their acolytes in the financial industry can successfully forecast the upcoming moves of the market (or of this or that sector, commodity, currency, or bond yield).

While few modern investors may fall for the reliability of "sell in May and go away," they nevertheless yield to other manifestations of this sense of inferiority and dependence upon the prognostications of a class of financial tea-leaf readers. This shows the continuing truth of an observation made in 1929 by Harvard Business School Professor Harry W. Dunn, who called this problem "the persistent delusion" -- "that coming moves of the stock market can be successfully guessed, bringing greater rewards to those relying on that procedure than are obtainable through the adoption of any other policy."

Let the adage "Sell in May and go away" become a reminder to investors to break free from such investing traps.

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A Conversation with Gerry Frigon

For further insight into the classic growth stock theory of investing, we share some quotations from an actual conversation with longtime money manager Gerry Frigon, President and CIO of Taylor Frigon Capital Management:

"No one knows what they're doing, when they're trying to time the market. We've never done that. . ."

"Wealth is never created unless you're an owner. Wall Street has sold a line of bull that there's a magic to picking this trend or that trend, the idea that 'We know better.' And this has been reinforced by the twenty-four hour financial news cycle. Built into the system is a sense of inadequacy in the investor, that they need this intermediary to know all this special lingo and stuff. It all reinforces the whole delusion that they [Wall Street] know something that someone else doesn't."

"There's no magic to this. Stop relying on the witch doctors of the financial world. Common sense is the best guide: what are the businesses we want to own? The paradigms that are changing?"

"Historically, solid businesses end up surviving. Deworsification just showed that it blows up. We aren't saying don't diversify, but the bill of goods that people have been sold that 'alternative investments,' and 'commodities trackers,' and 'international this and that and the other' will prevent a decline from being too bad has been shown to be just that -- a bill of goods."

"In terms of diversification, you're going to be wrong about things, and you have to put yourself in the position where you don't get slaughtered, but also where you can make some money when you're right, as opposed to the 'mass-managed money' and 'own everything' approach."

"Everyone's looking for an algorithm to beat the market, but the answer to the question of 'who's going to innovate next?' is something no economist or algorithm can tell you."

For posts which touch on some of the concepts discussed in the above conversation, see:
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"Inflection points" and the Growth Stock Theory

The financial media is currently full of market watchers speculating as to whether or not we are passing through a major "inflection point."

Recent discussion has ranged from the broad question of whether now is the time to bring money off of "the sidelines" and into the equity markets, to narrower questions such as whether it is time to switch from "value" to "growth" or from small-cap stocks to larger-cap ones (see, for example, this recent article on that question).

Practitioners of the classic growth stock style of investing should understand that these sorts of questions arise from strategies which are diametrically opposed to the foundations of the growth stock theory. They arise because much of the investment community today follows strategies which attempt to find the right time to "overweight" one area or another, trying to call the inflection points at which one should shift from being overweight to underweight or underweight to overweight in any number of areas, from international securities, to small-caps or large-caps or mid-caps or micro-caps, to this sector or that sector, and on and on.

We have discussed the folly of this type of approach in many previous discussions, such as last August's "Drawbacks of sector rotation." One important observation that stands out in times like those we have experienced in 2009 thus far is a comment that growth stock investment pioneer Thomas Rowe Price made in his 1973 essay, "A Successful Investment Philosophy based on the Growth Stock Theory of Investing."

In describing the genesis of the growth stock theory, Mr. Price wrote:

"In the early 1930s, after 10 years experience in the investment business, several things were learned which helped to formulate my investment philosophy:

1. That I did not have the ability to correctly forecast the trends in the stock market.

2. That most other people, including various stock market services, were unable to predict the market over an extended period of time. The various systems usually failed at crucial turning points in the market.

3. That most of the big fortunes of the country were made by men retaining ownership of successful business enterprises which continued to grow and prosper over a long period of years."

The phrase which stands out to us in looking back at 2009 thus far is "failed at crucial turning points in the market." It strikes us that Mr. Price's observation from the 1930s is certainly applicable to the situation today.

Back on March 2, 2009, we published a post entitled "Don't get off the train," in which we stated that "As unbelievable as it seems now, there will be a turn in what seems to be a never-ending bear market cycle." While we did not presume to predict exactly when that would be, we warned investors that getting on the train after it starts to move is a lot harder than most people think. As it turned out, a major turn was just seven days away, which can be seen from the market chart above.

The broader lesson, which applies not just to the markets of the past several months but to investing at any point in time, is that investment strategies (the "various systems," as Mr. Price calls them in his essay) that attempt to predict the market (or one sub-segment of the market, whether a sector, industry, geographic region, capitalization size, or whatever) usually fail precisely at these "crucial turning points."

Even if you meet someone who has correctly predicted one or two of them, the belief that someone or some system can do so correctly for the thirty or forty years (or more) that make up a typical investment lifetime is delusional.

Nevertheless, much of the "wealth management" industry follows just such an approach, even as they almost universally denounce "market timing." So-called "core-satellite" strategies, in which a "core" of supposedly conservative (often index-based) holdings is surrounded by a few "satellites" which attempt to overweight sectors or geographies or capitalization ranges that are about to produce outsized returns, are very common. Even those who use "only indexes" or "only ETFs" typically shade their index or ETF holdings to favor growth at one time and value another, or large-cap one year and small-cap another, or a few selected sectors at the expense of others.

All of these contemporary strategies are based on predicting markets, and are typical of what Mr. Price describes in point #2. The alternative, which he describes in point #3, is to base your investment upon ownership of successful businesses. This is a world away from the market guessing strategies that dominate the landscape today.

Investors should read Price's three points above very carefully, and be sure they understand the gulf between the approach in point #2 and the approach in point #3, and they should resolve to base their investment foundation on that described in point #3. Doing so will free them from having to guess the "crucial turning points in the market" on which market-timing strategies are dependent, and at which history suggests they usually fail.

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The Poison of 1974

Cars have changed a lot since 1974, as this advertisement for the 1974 Ford Mustang II illustrates. Regardless of whether cars have come as far as they should have over the past thirty-five years, the fact remains that what was then thought to be modern and forward-thinking in an automobile looks pretty out-of-date today.

However, when it comes to money management, an idea that was thought of as modern and forward-thinking in 1974 continues to grip much of the industry. "Modern portfolio theory," so-called, is a set of mathematical concepts developed by academicians in the 1950s and 1960s that purported to determine the ideal portfolio for any level of desired risk (and purported to be able to mathematically define risk precisely enough to be able to accomplish portfolio optimization at various desired risk levels).

As we have explained previously, this academic theory began to infect professional money management in 1974 as a reaction to the severe bear market of 1973-1974. See "Beware of the witch doctors of modern finance" for that discussion, along with quotations from influential voices such as Peter L. Bernstein and Paul A. Samuelson who declared the dawn of "the new world of the academics with their mathematical stochastic processes" over the old world of money managers with investment methods derived from practical experience in the stock and bond markets.

We have always believed that this infection of the financial world with "modern portfolio theory" was a relic of the 1970s that should have been scrapped along with many other dubious ideas of that decade that have since been repudiated.

As we have explained in many previous posts, such as this one and this one, investment is ultimately about matching capital with innovation, and innovation is something that mathematical models cannot predict.

We have also pointed out that the global financial crisis of the past eighteen months should have exploded the foundational assumption of Modern Portfolio Theory that risk can be mathematically modeled and diversified away using portfolio optimization techniques that turn out to be dependent upon speculative calls about the direction of commodities and currencies.

The most recent bear market should serve as the wake-up call that ends the thirty-five year sleeper hold that the theories of 1974 put on the financial services industry. Unfortunately, the current financial industry is so built upon the tenets of Modern Portfolio Theory that it can accurately be described as a product of Modern Portfolio Theory, as we have explained in many previous discussions of the "intermediary trap."

It is clear that a huge number of investors today have correctly concluded that there is something wrong with the current set-up, but they don't know exactly what it is. Numerous articles are appearing in financial journals, such as this recent WSJ article, documenting the dissatisfaction with the state of affairs on Wall Street, without understanding the underlying cause of the problem.

In fact, a few months ago we linked to an article by the same journalists which interviewed a variety of disgruntled investors who were trying to change their strategies after the bear market, and yet the irony of the story is that the investors are fleeing to "structured products," "managed futures," "hedge-fund-like mutual funds," and "trading systems" based on "computer models." In other words, outgrowths of the same old Modern Portfolio Theory that took root in the 1970s, albeit dressed up in newer terminology.

The effects of the infection of 1974 are potent and deeply rooted. We would recommend that all investors, as well as journalists who are writing about the current state of investing, examine this issue and take the time to understand it. Unless, of course, they drive a 1974 Mustang II.

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