Changing Investment Religions

Dave, another long-time companion in the battle, came by the office today. Dave, not a fancy or pretentious guy, went to college in the Midwest, and when I first met him in 1974, he had just been promoted from analyst to portfolio manager at one of the big Midwestern mutual-fund companies. He is a tough, smart, hard-working guy, and back then he was very much a fundamental investor. Subsequently he ran a major company’s pension fund where he put up excellent numbers. In 1987, he formed his own investment management company, which aggressively runs primarily institutional, benchmark-oriented accounts. At year end of 1987, his assets under management were a magnificent $72 million.

One interesting thing about Dave is that over the years he has completely changed his investment religion. For a professional investor, this is a huge, mind-altering event, comparable to a deeply religious person converting from Catholicism to, say, Judaism. Dave used to be a fundamentally driven, value investor, but now, in his maturity, he pays much less attention to the fundamentals and has evolved into a momentum investor. He pays a lot of attention to long-term relative strength patterns of markets around the world, sectors, and individual stocks.

As he expresses it, he lets the market tell him what groups and stocks to own rather than trying to tell the market what groups should do well. In other words, he looks for sustained relative strength. If a stock or a group of stocks are going up faster than the market, he will instruct his analysts to investigate them. Unless there is something seriously wrong with the fundamentals, he will buy them, and he will hold them until they start to lose relative strength. He will never buy a stock just because it is cheap. He will never try to be a bottom picker. He thinks that investors who buy underowned, unloved, and undervalued stocks are crazy. Buy and own stocks that are going up; sell and avoid stocks that are going down or sideways.

Dave’s performance has always been highly volatile. Hiring Dave is not for the faint-hearted. For example, his U.S. equity accounts were up 56% in 1991 when the S&P 500 (his benchmark) gained 30% and 31% in 1993 when the index rose 10%. On the other hand, he was down 23% in 1994 when the S&P eked out 1.3% and then lagged the index by small amounts in each of the next three years. He did very well in the late 1990s because he stayed with the trend and owned a lot of tech. In 1998, his U.S. equity accounts were up 61% versus 28% for the S&P 500.The next year they soared 90% when the S&P 500 returned 21%. His firm’s assets rocketed to $14 billion. His reward for that spectacular performance was that many of his clients took a quarter or half of their money away simply because he had done so well and their accounts had become so large.

As it turned out, they were half right for the wrong reason because, although he got hurt in the bear market that began in 2000, he didn’t do much worse than his benchmark. He did not get killed. His system got him out of stocks that were about to collapse.

For example, he had a big position in Nortel, which he had bought at a price of around 16. I visited Nortel in April 2000, and you didn’t have to be Benjamin Graham to figure out that this was an accident waiting to happen. The stock was selling at a hundred times exaggerated earnings. Its accounting was a farce. Instead of doing research and product development, the company was paying ridiculous prices to acquire tech startups. It was in commodity, highly competitive businesses. The executive vice president spun me a bunch of baloney about “the innovator’s dilemma and disruptive technologies.” He told me how “Nortel had a virtuous circle going.” It was crazy! Nortel was no growth stock! It was a highly cyclical capital goods company. It reminded me of the new-era crashes of the 1970s.

I came back to New York and called Dave when Nortel was at 62. He listened carefully to my concerns and said, “You may well be right, but I am going to wait for the market to tell me.” The stock kept going up and hit 75 in May. Then, that fall, with tech beginning to get hit hard and the stock at 60, one morning Nortel announced that fourth-quarter earnings were going to be down substantially, and that its order backlog was declining. Nortel opened late that morning, down 12 at 48. Dave sold his whole position that day. Over the next two years the stock went to 3.

“Only egotists or fools try to pick tops and bottoms,” he said with a smile on this visit. “Which one are you?” Now he likes U.S. tech, Asia, Japan, and the emerging markets. I asked him about the U.S. drug stocks, which have been beaten down, are as cheap as they have been at any time since Hillary Clinton attacked the industry in the early 1990s, and which we own. “No interest whatsoever,” said Dave. “They look weak and weaker. Why would you want to buy stocks like that? You are just guessing that they have stopped going down. Wait until the market tells you.”

Cyril and Madhav came in, and Dave talked some more. He got on my Bloomberg and showed us the charts of Hong Kong, China H shares, the German Dax index, and Tokyo. In each case, when the market broke through to a new high, it immediately thereafter surged about 10%. “It’s like smoke going up a chimney,” said Dave. (At the time he thought the S&P 500 was going to do the same in the next month or so, and he was right.) He recognizes that U.S. stocks, in general, are expensive, and he is unsure about the strength of the economy. But he refuses to make judgments.“ The market is smarter than I am or you guys are,” he says. “Right now the markets are telling me that they are going higher, that Asia is a tiger again, and that the U.S. economy is coming on, so I want to own stocks. Maybe the markets know something about the world economy we don’t. I want to own stocks with strong cyclical earnings streams.”

Listening to Dave, I couldn’t help but think of similar comments inReminiscences of a Stock Operator , which I wrote about in Chapter 3.The protagonist, the Old Turkey, who describes himself as a momentum trader and a student of greed, at one point in the narrative, gave this advice when suddenly stocks stop responding to good news:

When the market leaders begin to lose relative strength even though the news is still very good, and buying strength and selling weakness no longer works, get out of stocks in general because the game is over. It is enough for the experienced trader to perceive that something is wrong. He must not expect the tape to become a lecturer. His job is to listen for it to say “Get out!” and not wait for it to submit a legal brief for his approval.

As I said before, Dave’s extreme, momentum-following style results in huge swings in his performance versus the benchmarks. When he is hot, he is very hot, and when he is cold, he is ice. During the growth stock era in the late 1990s he literally shot the lights out. Then, when the worm turned from growth to value, he underperformed. His volatility has scared the daylights out of the prudent plan sponsors, even though his results, over the 10 years that ended June 30, 2005, are 600 basis points a year better than the S&P 500 and 800 basis points better than the Russell 1000 Growth Index. However, his assets under management fell to $6 billion at the end of 2002 and have been static at around $8.5 billion for the last four years. Institutional investors apparently can’t tolerate his volatility, which is crazy because what they should care about is long-term performance. In any case, I love and admire Dave. He is no cowardly, cringing benchmark clinger, no closet indexer. He also admits he follows momentum, which most of us do, too, but won’t admit to. Dave is a real investor man.

Dave’s style is not my style, which is value, contrarian, and distrustful of momentum. In fact, my investment religion is almost the exact antithesis of his. However, I have deep respect for Dave’s judgment and intuitive feel for markets. There are periods when momentum investing works wonderfully, and we need to keep in touch with the best practitioners. I talk to Dave every couple of weeks.

-Extract taken from Hedgehogging. Copyright © 2006 By Barton Biggs. Reprinted by arrangement with John Wiley & Sons, Inc.

		Editor’s Note: Barton Biggs spent thirty years at Morgan Stanley. By the mid-1990s, Morgan Stanley Asset Management was annually adding more new institutional accounts than any of its competitors. At various times during this period, Biggs was ranked as the
number one U.S. investment strategist by the Institutional Investor magazine poll and then, from 1996 to 2003, as the top ranked global strategist. In June 2003, Biggs left Morgan Stanley and with two other colleagues formed Traxis Partners—the largest new hedge fund of 2003. Traxis now has well over a billion dollars under its management. Biggs has spoken at forums in every major country and has appeared on CNBC and other programs on more than 300 occasions.