Thomas Rowe Price and the Growth Stock Theory of Investing

Kudos to Andrea Riquier of Investors Business Daily for her informative and timely story on Thomas Rowe Price, Jr. (1898 - 1983), and his timeless investment philosophy, entitled "T. Rowe Price was right with bet on American growth."

Her article points out that Price's convictions about the benefits of ownership of shares in well-run businesses operating in "fertile fields for future growth" were strong enough for him to decide to launch his investment advisory business in 1937, in the depths of the Great Depression. The parallels to the situation today could not be more pointed. 

History has borne out time and again the validity of the investment philosophy in which he believed and which formed the foundation of an investment portfolio which achieved a compound annual growth rate of 9.4% over the course of thirty-seven years between 1934 and 1972, according to a paper Mr. Price wrote outlining his growth-stock theory in 1973, soundly beating the market averages over the same period. He calculated that, if income had been reinvested in the portfolio at the end of each year, a $10,000 investment made on 12/31/1934 would have grown to a value of $2,712,011 on 12/31/1972.

Taylor Frigon Capital Management's founder and Chief Investment Officer, Gerry Frigon, whose investment discipline is descended from that of Rowe Price by way of being descended from the investment discipline of the late Dick Taylor, who was a portfolio manager with Mr. Price, is quoted in the article as well, explaining that one of the core principles of the approach is to concentrate on the investment merits and potential of the underlying business rather than the stock and its movements in the exchanges: a crucial distinction which seems so obvious and yet which continues to elude investors large and small, professional or amateur, to this day.

We have written many previous articles expounding some of the foundational concepts of what Mr. Price called "The Growth Stock Theory of Investing." Some of these include:

• "The Classic Growth Stock Investment Philosophy"
• "The business focus of the great 20th century investors"
• "'Inflection points' and the Growth Stock Theory"
• "Beautiful Growth Companies, Part III"
• "Look for paradigm shifts, part 2"

At a point in history at which many investors, and many of the voices featured in the media, seem to be giving up on the possibility of ingenuity, innovation and even free enterprise itself, it strikes us as extremely appropriate to think back to those dark days of the 1930s, when Thomas Rowe Price was formulating the pioneering investment philosophy which was built upon finding well-run, innovative companies operating in fertile fields for future growth, and owning shares in those companies through the ups and downs of the various economic and market cycles. His vision and courage to follow his convictions were certainly rewarded by success over the years, both for his portfolios and for those who invested with him using that approach.

Thanks to Andrea Riquier and to Investors Business Daily for reminding us all of this uplifting lesson.

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John Maynard Keynes R.I.P....And Keynesian Economic Theory!

John Maynard Keynes (right) in 1946, at the inaugural meeting of the IMF Board of Governors.

Last week, economist Scott Grannis published a remarkable post over at his Calafia Beach Pundit blog in which he says: 

The past six years in effect have been a laboratory experiment to determine whether Keynesian economic theory is valid. The result? Keynesian economic theory is (or should be) officially dead. It doesn't work. Government can't boost the economy by borrowing or spending more money. Politicians will be unhappy to hear this, of course, since they would prefer that we think they can dispense growth and prosperity on demand. Those who insist in perpetrating this myth should be voted out of office.

These are strong words, but Mr. Grannis backs up his statements with data. He concludes that the private sector -- that is to say, men and women in the United States going to work in areas outside of the "public sector" of the government -- generated $8.9 trillion in profits over the course of the past six years (an all-time record), but the reason things feel so terrible is that "the federal government borrowed 83% of those profits to fund a massive increase in transfer payments, income redistribution, bailouts, subsidies, and a modest increase in infrastructure spending." 

As a result, he says, almost all of "the most incredible surge in profits in modern times was squandered by our government, flushed down the Keynesian drain."

When he refers to "the Keynesian drain," Mr. Grannis is referring to John Maynard Keynes (1883 - 1946), who championed the theory that economic weakness and recession is caused by a lack of consumer demand, and that government can "stimulate" demand by giving money to consumers, either directly or indirectly, in order to cause demand to pick back up and thereby jumpstart the economy.

Elsewhere in his post, economist Grannis explains the problem with Keynesianism in a nutshell: "The government can't stimulate the economy by borrowing from Peter and sending a check to Paul, because that doesn't create any new demand -- it's like taking a bucket of water from one end of the pool and pouring it into the other end; the level of the water doesn't change."

There's an even bigger problem with Keynesian economics which Mr. Grannis doesn't mention, but we will: it's immoral. Not only does "robbing Peter to pay Paul" not work -- it wouldn't be right to do so even if it did "work." That being said, it also does not work, in addition to being immoral, and as Mr. Grannis points out, the past six years provide ample proof (on top of abundant proof that already existed prior to 2008) that Keynesian economics absolutely do not work.

In fact, all the way back in January of 2009, when the economy was still in the middle of the financial panic and the turn that took place on March 9 of that year was still nearly three months away, we published this post criticizing the proposed "stimulus plans" and containing a link to an excellent video by Dan Mitchell entitled "Keynesian Economics is Wrong: Bigger Government is Not Stimulus." That video is well worth another watch today, and it contains extensive evidence stretching from Herbert Hoover to Gerald Ford to George W. Bush that government spending financed by government debt does nothing good for an economy.  

That video concludes that, since the theoretical problems with Keynesianism should be well known by now (taking money from one side of the pool and putting it in on the other does not create any new growth), and since the historical track record of Keynesianism is also clearly terrible, the real reason that Keynesian policy is still around is probably that politicians like to spend other people's money, and "Keynesian economics" provides them with a academic cover in order to do so (and, we might add, a host of academic-sounding terms, such as "stimulus" and "multiplier" to use in speeches, as they redistribute the wealth).

Mr. Grannis seems to echo this conclusion, when he notes towards the end of the passage quoted above that politicians don't want to learn that Keynesianism is a bankrupt economic theory, because "they prefer that we think they can dispense growth and prosperity on demand."

In fact, it is likely that both Mr. Grannis and Mr. Mitchell have hit upon the real reason that Keynesian economics is even remembered today anywhere outside of the history books. According to Austrian economist F. A. Hayek, who knew him personally and had many long conversations with Keynes during his life, Keynes wasn't really even that interested in economics! In the interview below, Hayek remembers his friend Keynes and admits that Keynes had one of the most brilliant intellects that he had ever encountered, but that economics was really "just a side-line" to Keynes, and that Keynes never even bothered to read the economic thinkers who published important contributions to the field in English, let alone those who published in German! Keynes was really into many other subjects, but "he knew very little economics," according to Hayek (we have written about the tremendous contributions of F. A. Hayek to the subject of economic freedom in previous posts such as this one and this one).

It is clear that Hayek had a great deal of admiration for his friend Keynes, but that he recognized that economics really wasn't Keynes' area of expertise, and that the theories that Keynes published were actually very shoddy and in fact dangerous. At another point, Hayek once opined that Keynes in later years seemed to be moving away from the economic theories that came to be associated with his name, but that Keynes died in 1946 and his followers carried on with "Keynesian economics" in his name, in a direction that Keynes himself would no longer have agreed with.

In any case, the world now has nearly seventy more years of evidence that Keynes' earlier theories were just plain wrong, and that they should be abandoned. Politicians should not be allowed to use "Keynesian economics" to give the impression that they can "dispense growth and prosperity on demand," in the words of Scott Grannis. 

Keynes himself may have dropped that idea before he passed away in 1946 -- we wish Keynesian economics would find its way into the history books as well, before it does any more damage than it has already done.

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Common Sense From George P. Schultz

For years we have been commenting on what we believed to be the necessary ingredients for a healthy and growing economy.  More recently, given the subpar growth we have witnessed in the US economy, we have suggested that while the economy "gets by in spite", excessive government intrusion in the affairs of businesses and individual citizens alike, is the primary culprit holding back what would otherwise be a very strong economy. Incredible technological advancements achieved in communications, healthcare, energy production, etc., have been so pervasive that we should be experiencing unprecedented growth - but we're not!

A simple review of previous posts like this one, or this one, or this one, will give you insight into our thinking on what ails the economy in this era.  We certainly offered our solutions, in those posts and others, to what has been over a decade of mismanagement.  But none so eloquent and simple as those proposed recently by former US Secretary of the Treasury, Labor and State George P. Schultz.  In his Wall Street Journal op ed "How To Get America Moving Again", Mr. Schultz offers his sage advice on what it would take to get our economy on track, and quickly.

He makes these points in his plan to revitalize America:

"Cleanse the personal income tax system of deductions and lower the marginal rates..."

"And let's lower the corporate tax rate to be competitive with the rest of the world."

As per the current regulatory maze: "Overhaul the current complexity so that even small business can see how to comply without having to hire compliance advocates that they can't afford."

"...why not take the mystery out of the Fed?  The Fed can establish a rules-based monetary policy..."

"Get control of spending....  One way is to change from wage-indexing to price-indexing as a method of  calculating benefits, and apply the change only to people under the age of 55."

On healthcare: "The main risks in the health care area are catastrophic events that have high costs, so high-deductible catastrophic insurance is what is needed."  He continues by advocating the expansion of Health Savings Accounts, more emphasis on both public and private neighborhood health clinics.

On the military:  "Let's put our military to work figuring out what they really need.  We want no-nonsense people in charge.  We want to do away with all nonsensical across-the-board sequester rules.  But we must have a robust military capability.  And then we need to conduct ourselves in a credible way."

It would be wise to adhere to this principled, common sense approach.  Is anyone in Washington D.C. listening? HT to Scott Grannis.

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Be sure to head over to the Quarterly Investment Climate section of our website, where the latest Investment Climate (July 2014) has just been posted.

This quarter's commentary is entitled "Zero Interest Rates are not normal!"

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The "passive" investing myth

image: Wikimedia commons (link).

Over the course of three decades in the professional investment business, we've heard our share of arguments for so-called "passive investing," the idea that investing in securities designed to mimic the broader market represents the safest, least expensive, and most certain way to achieve the best possible investment outcomes for the largest number of people. But is there really such an animal as "passive investment" at all? Our opinion on the subject is similar to our opinion on the existence of Bigfoot: we agree that there are many people who claim to have seen such a creature, and we remain open to seeing the evidence, but so far we have not seen enough evidence to believe in the existence of either one (Sasquatch or "passive investing").

The arguments in favor of passive investment are almost always coupled with equally passionate criticisms of "active management" (actively selecting investments in an attempt to provide a better return than the broader market). These arguments usually center around cost (active managers charge more than passive investing vehicles), performance (the allegation that the majority of actively-managed investment vehicles fail to achieve the performance of the broader market over time), theoretical soundness (many passive investment advocates believe that it has been academically proven that it is impossible to beat the performance of the broader market over time, due to the efficient market hypothesis in one of its three main variants), and motive (because passive investment advocates believe that it is almost certainly impossible to beat the performance of the market, they often attribute nefarious motives to anyone who continues to try to do so, usually involving the desire to make money at the expense of all the poor suckers who have not yet accepted the dogma of the passive investing evangelists). 

Occasionally, the commitment of active investment practitioners to ideals such as human freedom and self-determination are even called into question, such as in the inflammatory arguments of Rex Sinquefield, who in a debate on the subject argued that "only the North Koreans, the Cubans, and active investment managers" have failed to accept the premise that "markets work." Sinquefield thus equates faith in the system of free enterprise with the belief that no one within a free enterprise system should evaluate individual businesses within that system prior to investing capital in those businesses: unless you give money equally to all the businesses in the market, you might as well go take up residence in Cuba or North Korea. This strikes us as a singularly nonsensical assertion.

We have written on this subject many times in the past, in previous essays such as the one linked above in which we quote Mr. Sinquefield and demonstrate that his arguments are incorrect (see "Free markets, free enterprise, Friedrich Hayek, and active allocation of investment capital"), and in other examinations of the issue including "The active vs. passive debate," "The emperor's new index fund," and "S&P takes aim at active management." 

In those previous writings, we argue that we put more faith in individual businesses (which can be analyzed for their soundness and their business prospects using methodologies which have been developed over the course of nearly a century), than in "markets" (which cannot), and give sound reasons why investors should as well. Today, however, we are going to take a step back in order to question whether "passive investment" exists at all.

Passive investment is defined by Burton Malkiel in his book A Random Walk Down Wall Street (first published in 1973) as "simply buying and holding an index fund" (9th edition, page 345). But what is "an index fund"? The term is broad enough to include securities which are structured as an open-end mutual fund (the first and still most well-known index funds took this form) as well as exchange-traded funds (which can be traded like stocks through brokers for commissions, can be sold short, and avoid some of the tax drawbacks inherent in the open-end mutual fund structure). However, in either case, the term refers to a portfolio which has been assembled by someone (we won't call that someone a "manager" in order to avoid offending the passivists) in order to replicate the performance of some segment of the securities trading in a market.

But an index itself is a portfolio, and it is assembled based on a variety of criteria. If you want to be a passive investor in equities, then you can choose from funds designed to track the venerable S&P 500 (descended from the first cap-weighted index created in 1923), a plethora of other S&P indexes (such as the S&P Composite 1500, the S&P MidCap 400, and the S&P SmallCap 600), the Dow Jones Total Market Index, the various Russell and Wilshire indexes, the MSCI equity benchmarks, and hundreds of others -- just to name some associated with US equities. 

Because there are actually over 10,000 publicly traded companies in the US equity markets alone, each one of these indexes which contain fewer than that number of securities is actually a portfolio, constructed by some manager, according to some criteria with actual decisions being made regarding what to do when new companies enter the overall market (when Facebook went public in May of 2012, for example, it took some time before the name was finally added to the portfolio of companies included in the S&P 500, near the end of December, 2013).* Each one consists of a list of securities and a weighting of the securities on the list -- which is the definition of a portfolio (just like the lists created by active managers, who may use different criteria but are doing the exact same thing). There have been literally thousands of such indexes (that is to say, portfolios) created as the "passive" craze has gathered steam, just as any market tends to fill up with various products designed to offer consumers choices and to compete for their dollar.

So, passive investors are using portfolio managers just like anyone else who decides to outsource the selection of the securities they buy instead of selecting those securities themselves. We don't think there's anything wrong with this (after all, we also create portfolios for those who have decided that they themselves don't want to select the securities in which to invest). We happen to believe that there are other criteria by which securities can be best selected for inclusion in a portfolio in addition to those typically utilized by those who construct portfolios that they call "indexes" (for example, we evaluate various aspects of the management team, and various aspects of the potential for future growth in the company's market, neither of which are typically evaluated by those who construct indexes), but they are obviously using criteria to decide what gets into their portfolios just as we are (otherwise, why did it take Facebook over a year to gain access to the S&P 500, and why do different indexes created by different companies such as Russell or Wilshire contain different names from those created by Standard & Poors or Morgan Stanley?).*

We believe that the criteria we use to assemble a portfolio are valid criteria which have stood the test of time and which have produced valuable results for investors in those portfolios -- better results, in fact, than were obtained by investors in most other portfolios assembled by other criteria (whether those portfolios were labeled "active" or "passive" or some other label). But, we don't bash the professionals who are assembling portfolios using methodologies other than our own, and we certainly don't label them "communists" or "crooks" or the other unfortunate sobriquets sometimes employed in this debate.

If they want to label what they do "passive," that's their own choice and their own marketing strategy, but investors should consider how accurate that label really is. Nowadays, investors following a so-called "passive" strategy actually have two or more layers of management that could arguably qualify as "active." 

First, of course, there is the active management of those who are assembling the indexes themselves: who are deciding upon the criteria, and then -- when new companies such as Facebook enter the market -- are deciding whether and when to add those companies to their list or not. Because the markets are always changing, with new companies issuing new securities (and new debt instruments, in the case of bond indexes, etc), this is a constant process, and one which could very well be classified as active to some degree. 

Second, there is evaluation which takes place at the "securitization" level, in which financial services firms create the open-end mutual funds or the Exchange Traded Funds (ETFs) which investors can actually buy and sell through a broker-dealer or an investment advisor. Here again, some level of management must take place on a fairly constant basis (you can label it "active" or "passive" if you want, but it is obviously a full-time job for a lot of people). Creating these vehicles involves choices as to how many of the names in the index being tracked will actually be included in the investment vehicle (giving rise to greater or lesser levels of something called "tracking error"). When changes are made in the list that is the index, the curators of these vehicles must decide whether or not to include those changes in their own securities, and if so, when and how to make those changes.

Then there is the level of management involved in selecting a mix of securities appropriate to a particular investor, whether that investor is an individual, a family, or an institution such as a foundation, a university, or a state employees' pension and retirement fund. This mix of securities will be based to some degree upon goals, timelines, and a philosophy about the best mix of investments to reach those goals, just as with any other investment. If an individual or family decides to make those decisions for themselves, then they are acting as their own "advisor" in that case, while still hiring the two levels of advisors already mentioned. Nowadays, however, there are a whole host of advisory companies offering their services in the arena of constructing a portfolio of "passive" investments best suited to an individual or family's goals, timelines, and risk tolerances (and at the institutional level, nearly 100% of these decisions have been delegated to a professional class of investment advisors for decades). 

We call this level the "intermediaries," because they stand between the end-investor (the individual or family or institutional client) and the portfolio manager. In this case, the portfolio management is split between two groups -- the big firms such as Standard & Poor's and Russell which make the index lists themselves, and the firms that assemble the index funds or ETFs designed to mimic the lists created by S&P or Russell, and who make decisions at their own level about which securities on the list will get into the ETF or open-end fund that they are managing. 

Again, we're not saying that there is anything inherently wrong with this set-up, although in practice there can be problems if the intermediaries frequently change strategies in mid-flight. However, we believe it is disingenuous to paint such services as qualitatively different from the rest of the investment advisory world, and to paint those services as somehow more "pure" and "wholesome" because the portfolios and securities selected use "index-style" criteria rather than "business-style" criteria (and to cast aspersions upon anyone who selects securities based on business-related criteria). It is true that such service providers typically charge lower fees than those managing securities based on business evaluations, but they are usually trying to make up in volume what they give away with lower fees. They are not working for free (nor do we argue that they should be, since they are performing services which their clients find valuable and are willing to pay for).  However, this is just another argument which shows that their activities are not "passive," since true passivity would imply a lack of activity and a hence a lack of any fee.

In addition, most of these "intermediary" advisory services also perform rebalancing activities, after they are finished with their initial "portfolio assembly" activities. We would argue that there really is no way to characterize rebalancing decisions as passive. Rebalancing necessarily involves a host of "active"-type questions, such as: When do we rebalance? Based upon what criteria? How "out-of-tolerance" must a position in a portfolio become before it warrants trades designed to bring it back in line with the general model weight? These are all decisions over which different managers could debate with various merits, and whose answers will differentiate the management style of one manager from another. 

In short, "passive" investing is really a myth, or an illusion, or a marketing ploy which enables some financial services professionals to say, "I'm passive, but I get to change what names I own when I decide to do so (just like an active manager), and I get to decide when to buy and sell and how much to buy and sell (just like an active manager), and -- while I'm at it -- I get to act as though I'm the only type of financial services firm that actually looks out for my clients' best interests, and that no one can  expect better results than the results that I give my clients, regardless of what criteria they choose for doing the same things that I'm doing.  After all, I have the "academics" on my side!" Some of these "passive" intermediaries make their initial portfolio-assembly or ongoing rebalancing decisions using algorithms or computer models that they have created, but this does not make them any more "passive" than a hedge fund whose managers have created an algorithm to automate buy and sell decisions based on their own goals and timelines and market changes and events.

The comeback from those who are convinced of the inherent superiority of the indexing model to all of this, of course, will be to say that with their lower fees and with the bad track record of most openly-active managers, their portfolio-management, portfolio-assembly, and portfolio-rebalancing criteria are the best for the largest number of clients. We would challenge that assertion, but even if we grant it temporarily, we would say "Fine -- you can say that if you want to, but don't pretend that you're offering something that is quote-unquote 'passive': there is no such animal."

Further, we would argue that the bad track record of "the average mutual fund" (which advocates of index investing are so quick to point out in their marketing material) is primarily due to the fact that most mutual funds tend to invest in "markets" rather than "businesses," which we believe is not the best recipe for success (at least for their investors).  Essentially, the typical mutual fund has become so large that it simply is the market!  We have often said that if this is the real problem with most mutual-fund investment records, the solution is not to run away from selection by business criteria altogether (which "passive" or index investing advocates do almost by definition).  

In the end, it comes down to a question of what investment philosophy you believe is best for selecting investments. There are different beliefs on this subject, just like with anything else, and labels can be helpful in making distinctions between different philosophies. Investors should realize, however, that the "passive" label is misleading -- and it is by no means clear that the philosophy of investing associated with this label is the best way to select companies in which to invest.

We intend to publish a series of future articles exploring this topic further.

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Facebook (FB). Had they outsourced their portfolio management to the creators of index lists such as the S&P 500, however, they would have been forced to own it. At the time of publication, the principals of Taylor Frigon Capital Management did own securities issued by Morgan Stanley (MS).

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