Review & Outlook

Our take on the investing, financial, & economic themes of the day

Fourth Quarter 2015 Appraisal Letter

As the opening theme of this quarter and year-end letter, I want to examine a popular business maxim: “What gets measured, gets managed.”

The maxim comes courtesy of management consultant Peter Drucker, who was much honored around the middle of the last century. I remember reading his books and articles as a graduate student. Though developed long before the Internet, biotech, the rise of China, and a thousand other things, his maxim seems appropriate to the perilous times and the volatile markets, in which we find ourselves. In other respects, however, the rule does not seem to work for investors, at least not in full.

What is everywhere measured these days is the price of investment assets. The media are full of it, especially this time of year. And it is not just the media. We are guilty too. On the first page you see our customary presentation of the price performance of bellwether stock and bonds for the year 2015, and on the performance page for your portfolio you see our customary presentation of price change, plus income, for each asset class as well as the whole portfolio, as measured for the latest month, quarter and year. And we are not unusual in this. It is standard practice in the industry to measure price in all these ways. In fact some managers put all this price information up on their website so clients can watch it update minute by minute, even second by second.

This is a problem. What all this measuring of price really means, to pick up on Peter Drucker’s rule, is that what some investors, governments and companies are doing, or trying to do, is to manage prices, and that cannot be done no matter how hard you try. The price of an investment in a free and open market comes as the result of other goals pursued and achieved. But governments, corporate managers and individual investors will try anyway. One thinks of current efforts in China to dictate stock prices, or quantitative easing in Europe and the US. Lots of examples to choose from.

Public companies sold record amounts of bonds in recent years, including last year. Many did not use the proceeds to build new plant and equipment or train new employees, which would have been the appropriate and prudent thing to do. Rather they used the proceeds to buy back their own stock. The stock buy-back technique makes reported earnings go up, which tends to have the effect of making the company stock price go up too, all without selling a single new product or service. A nice trick, except for the fact that the benefit is temporary. And, like slashing costs to boost short-term earnings, another form of financial engineering popular at the current time, a company can do it only so long before it is overwhelmed by unintended and unpleasant consequences. And the financial engineering saps confidence in the system, along the lines of what’s happening in China.

The problem is different for individual investors. When they focus on price change to the exclusion of other considerations, their investment time horizon tends to shrink from the long term, where real investing is done, to the short term, where speculating is done. The result is people who have to own stocks to get the return they need for future obligations, like tuition and retirement, don’t own stock. Instead they put their savings in cash, which has no return, or in annuities which pay a fixed but inferior return that’s also consumed by high fees.

The obsession with price measurement is particularly harmful now, when market volatility is so high. In my last appraisal letter ( October 12, 2015) I mentioned August 24, when in a few minutes the price of the Dow fell 1100 points in the greatest point drop in history, then rocketed up 900 points, then plunged 600 points in the afternoon. All this in one day. Small wonder record numbers of individuals are scared away from stock ownership, and allow their IRAs and 401(k)’s to sit idle in cash.

What’s the remedy? It would help if governments and corporations stopped trying to manage market prices. And it would help if the investment industry and the financial media measured dividends the way they measure price. In the 19th century, that is how it was done. Investors focused on dividends, their certainty of being paid, the rate at which they increased, and left stock price to take care of itself. A good system.

Let me turn to the economic and investment outlook. Last year was really unusual in one regard. Rarely do stock and bond prices end the 12-month period exactly where they began it, as occurred in 2015. The few times it has occurred, the next year has been very good for investors. Who knows why? Along the same lines, election years—and we are in an election year—also tend to be very good years for investors. Again, you can make your guesses why. So there are two forecasts on the plus side for 2016.

What is happening now is extreme volatility in the face of an aging and lackluster economic recovery. Corporate earnings drive stock prices, and corporate earnings are projected to rise a respectable 7.6% in 2016. Usually stocks would come in line with that. Monetary policy and energy prices are stimulative. Employment continues to pick up. These are all good signs. But it has been seven years since we had a major and sustained pullback in stock prices. We are overdue for one now. It is hard to say what could set it off, only that something eventually will. Huge geopolitical forces are roiling world markets.

Earlier I mentioned China, which is much in the news as I write this letter. The world’s second-largest economy, with the largest population, its top-down decision making is trying to do in the space of a few years what took the democracies of the West centuries to achieve. Several years ago the West thought the modernization of China would drive global economic growth for years to come. Now we see it won’t be quite so easy.

It is hard enough to identify the next crisis, harder still the appropriate investment response. So we would not try. Instead we would put our trust in enterprise, that is to say, in companies that can adjust to whatever the future holds. This has worked in the past.




Mark O’Brien