“When the facts change, I change my mind.  What do you do madam?”

- Winston Churchill, John Maynard Keynes, Paul Samuelson?

The CFA Institute’s second quarter 2017 Financial Analysts Journal included a research article penned by Martijn Cremers, professor of finance at the University of Notre Dame, entitled “Active Share and the Three Pillars of Active Management:  Skill, Conviction, and Opportunity.”

We are currently struggling with portfolio construction due to historically high stock prices and interest rates that provide a little reward, and I thought it would be beneficial to share with you Cremers’ understanding of what it takes to be a successful money manager:

The three pillars of skill, conviction, and opportunity are an application of the philosophical idea that practical wisdom involves the full triad of right knowledge, good judgment, and effective application and are not just a subset of these three components.  In other words, to be successful in the long term, one must have a good understanding, make the right choices, and have the practical ability to do so effectively.  It is insufficient to have a good understanding but not enough willpower or to have both but face practical obstacles that prevent effective implementation.  Perhaps worst of all is to have strong willpower and great opportunity but lack understanding.  Applying this triad of requirements to investment management means that successful managers must have (1) the skill to identify good investment opportunities appropriate for their clients, (2) the right judgment or willingness to choose prudently among the identified opportunities, and (3) sufficient opportunity or lack of practical obstacles to do so persistently.

After reading this, my memory flashed back to Kurt Lindner and the failure of his fund.  I believe it is a great example of what can happen if a portfolio manager relies exclusively on a black box formula, and has neither the skill nor conviction to adapt when market opportunities decrease due to a changing marketplace.

When I first entered this business, I made the same mistake almost every individual investor today does – thinking past performance is the best guide to future performance.  It takes a loss or two to recognize the fallacy of this approach to investing.  Being from Iowa, I was close enough to Missouri to adapt their “show me” attitude.  Kurt Lindner also did just that – he “showed” what a great manager he was through his fund’s performance. 

I will make an assumption that most of you have not heard of Kurt Lindner and his Lindner Dividend Fund.  Mr. Lindner created the fund in 1976.  From 1976 through 1995 the fund had recorded a 17% annual return.  This isn’t the absolute highest return in the mutual fund universe. However, it was earned without taking huge levels of risk, keeping most of Mr. Lindner’s long term investors out of the buy high, sell low club. The stated goal of the Lindner Dividend Fund was income, and while the fund also claimed that its secondary goal was capital appreciation, the return so far exceeded other income funds that Mr. Lindner became legendary. 

As a practicing CPA and auditor in the 1950s, Mr. Lindner created a numbers-driven formula for security selection that he calculated by hand.  Mr. Lindner was very secretive regarding how he selected investments, so we cannot know whether he tweaked the formula over the years.  What we do know of his investment approach came from his mentee, successor portfolio manager and future owner of the Lindner fund family, Eric Ryback. 

Peter J. Tanous interviewed Eric Ryback in 1995, the year Mr. Lindner died.  He published this interview in his book, Investment Gurus.  In the interview, Mr. Tanous was quite direct, asking:

Tanous:  Wait a minute.  There is a formula that is proprietary that guides your selection process?

Ryback:  Yes.  Absolutely.

Tanous:  That’s interesting.

Ryback:  I would be lying if I told you otherwise.

Tanous:  It’s not a black box, is it? 

Ryback:  It’s kind of a black box.  We put the numbers through.  All the companies go through a screening process.  We did it by hand until I bought the company three years ago, and then we put it on a computer.  Kurt was very concerned that if it went on a computer, anybody could get access to it.  We’ve tried to alleviate that problem.

Almost immediately after Mr. Lindner’s death, the fund started its downward spiral.  In 1996 Mr. Ryback transferred some of the fund management responsibility to others.  He became worried and began raising cash just as the market began the big tech rally.

In 1999 an investment consultant was hired to over-haul the fund. Fund names were changed, value was replaced with a growth mandate, and the total money at the fund shrunk from $3.5 billion to less than $1.5. Selling continued, as investors were pulling $6 million per day from the fund. As money fled, fund managers were fired and replaced with an investment committee led by Mr. Ryback. Money continued to leave the firm until it finally ended in 2004 when Hennessy Advisors, Inc. merged the remaining funds into their own, principally the Hennessy Total Return Fund and the Cornerstone Value Fund.

What is quite amazing is that Mr. Lindner was able to produce such a great record using a formula approach to investing for so many years. But then, he happened to be in the right place at the right time. His successor Mr. Ryback had the bad luck of being in the wrong place at the wrong time. Today we have seen an explosion in the use of computerized trading based on algorithms created by computer scientists, under the direction of academics in the fields of economics, finance, and psychology. These are essentially a “black box.” Granted, they may work, but if they do, neither you nor myself will ever know of their existence, as the creators, like Mr. Lindner, will lock them away for personal use.  What we do see are an unlimited number of investment products based on some statistical data that worked in the past.  We see the promotion of multiple computer driven investment management programs.  This list can go on and on.  For those who choose these offerings, just remember that they are designed to make a profit for the creators and salesforce. Your returns will be whatever is left.

In addition to black box technology, the marketplace has changed dramatically in the last ten years. The most damaging change for the few investment counselors like ourselves is the reduction of the number of companies available for direct investment on an exchange. In 1996 the number of listed companies reached a high of 7,322. In 2015 the number of companies was down to 3,700. Today, with a limited number of initial public offerings, the continuation of mergers and acquisitions, and companies going private, the number could even be less. 

This reduction in the pure number of companies combined with the fact that “big money” (the pension, profit sharing, 401k plans, and large endowments) has decided to invest in products that track the performance of the S&P 500 has created a top-heavy market place with an average higher price. To make things worse, conservative interest bearing investments do not offer a sufficient return to preserve purchasing power, let alone produce a positive real rate of return.

The combination of fewer companies, higher prices, and limited interest rate alternatives has placed a very large damper on our own “opportunity set” of large, powerful and high-quality companies available at a cheap price in combination with US Government or FDIC insured deposits. This is not the first time we have had to address our opportunity set over the years, but since it has been close to a decade since the last time a major change took place, a little review of portfolio construction is warranted.

As you know, we begin with setting a master allocation for each of you. This allocation is based on the amount of your savings that are exposed to risky investments (common stocks), or relatively safe US Government obligation and FDIC insured deposits.

What you may not remember is the diversification requirement of our risky investments. You can easily see the security diversification from your statements. You also see the sector weightings at the portfolio level. We have always sought to keep the percentage of your portfolio invested in each major economic sector close to the overall market weight while taking the greater of risk at the individual company level.

Therein lies the problem today. It has become increasingly difficult to cheaply maintain a neutral sector weight with individual securities alone, especially for our newer clients. Our solution is not new, but one we have used continuously since 1998, the first year an ETF was available for each major economic sector. If you see a sector ETF show up in your holdings, you will know the reason for its inclusion – meeting our sector diversification targets.

I opened with a quote from Winston Churchill with extra credit to John Maynard Keynes and Paul Samuelson (because each of them has a version of the same quote), and I will end with another from the Dutch Philosopher Spinoza.

“All things excellent are as difficult as they are rare.”

-Baruch Spinoza