TCS Daily


The Uncertainty Principle

By James K. Glassman - November 19, 2002 12:00 AM

"There remains an illusion among investors, especially professional money managers and analysts, that with enough digging and number-crunching, uncertainty can be conquered." Unfortunately, it can't.

That's the thrust of one of the best essays on investing I have ever read. The essay is the October letter to clients from Sam Mitchell, managing director of Marshfield Associates, a Washington money-management firm that has produced one of the best records in the nation in recent years.

Marshfield's stock accounts returned an annual average of 7 percent for the 36 months ended Sept. 30. That compares with an annual loss of 13 percent for the benchmark Standard & Poor's 500-stock index. An investment of $10,000 in 1992 rose to $52,000 (before relatively modest fees) this year, compared with just $24,000 for the S&P. Marshfield is generally considered a value-stock shop, though that term (which connotes a bargain-hunting bent) is far too simplistic for the philosophy the firm espouses. And, indeed, Marshfield has clobbered the Russell 3000 value index in recent years as well.

Mitchell's October letter is brutally honest, accurate and very disturbing. But, for investors with discipline and common sense, it offers hope at a daunting time.

The argument is that investing is fraught with uncertainty, with real risks. The world of business is complicated and unpredictable, and, as Mitchell writes, "the attempt to develop accurate forecasts of earnings or market prices is a fool's errand." Successful investors figure out strategies, not to overcome risk, but to live with it.

Still, Wall Street and Main Street abound with people who think the key to picking winners is to scrutinize income statements more carefully or to build better financial models. But, "no matter how strenuous and ingenious, efforts to slay the uncertainty dragon have always resulted in disappointment, anger, sub-par returns and occasionally criminal behavior."

This is the essential nature of stock investing: It's a dark and risky place. But, as Mitchell puts it, "if investors are to earn a return above the risk-free rate, they have no choice but to invest in securities whose returns are not guaranteed." In fact, stocks have, for the past 76 years, earned a return that, in the average year, is 5 or 6 percentage points higher than the risk-free rate. You don't get returns like that without taking risk.

Stock investors, especially since the early 1990s, have seen high returns as an entitlement. And politicians - as well as some journalists - play into these false expectations, promoting the notion that the only reason people lose out in the market is that someone is cheating them, or not telling them enough about the inner workings of companies. But such concerns are really a distraction. The nature of business is deep uncertainty.

Mitchell is not merely saying that stocks lack a money-back guarantee. He is saying that, when it comes to specifics on how a company will perform, hardly anyone knows anything.

"Managements themselves can tell only in rough terms what their profits are going to be from quarter to quarter," he writes. "As for what their numbers are going to be in a year, they are only slightly less clueless than the rest of us."

So what should stock investors do in the face of such uncertainty?

First, understand what you can know. Good managers, writes Mitchell, can tell investors "what they are doing to create and capture enough value to earn high cash returns for a long time, but it is unrealistic to expect them to know the precise timing, magnitude and results of their efforts." With these basics, it's possible to construct a reasonable range of earnings and cash flow over time - and, thus, come up with a range of values for a stock.

Second, realize that psychology plays a big role in the price that a stock carries in the short term. "We are always amazed," Mitchell writes, "at how fast and how much investor attitudes toward a company can change. Like schools of sardines, investors seem to change their perceptions all at once."

Warren Buffett's mentor, Benjamin Graham, observed this phenomenon long ago and developed a useful metaphor: Mister Market, a manic-depressive who sometimes gets so giddy he will buy your stock at a ridiculously high price and sometimes gets so depressed that he will sell you his own stock at a ridiculously low one.

"While prices tend to gravitate over the long run around a reasonable range of economic value, they can fluctuate much further above or below this range than a rational observer would anticipate," writes Mitchell.

So here are five Marshfield aphorisms to cut out and stick on your refrigerator door:

"1. Attempts at precision are futile (this means that 90 percent of what Wall Street tries to do is a waste of time).

"2. Buying a stock when investors are optimistic increases the probability of failure (and vice versa).

"3. There is no way investors can avoid the possibility that the value of their investment will plummet shortly after purchase, no matter how careful they have been."

"4. Success or failure is random in the short run (a couple of years, minimum), and lack of patience is a recipe for failure."

"5. Fear is just as deleterious to wealth building as greed."

Fear, I don't have to remind you, is rampant today. So what has Marshfield been buying lately for its clients? Here are three stocks that "share the same characteristics: quality, owner-oriented managements, cheap price relative to our estimate of value, strong industry position, solid long-term fundamentals and a cloudy-to-terrible short-term outlook."

• Duke Energy (DUK). Duke, an integrated energy company with a nationwide gas transmission system, regulated utility operations in the Carolinas, and power-generation and trading operations, has seen its stock fall by more than half this year. According to Mitchell, "everything that could go wrong has done so all at the same time." Duke recently received a federal subpoena for information on its activities in California energy markets. Recovery? It's hard to say how long these conditions will last, says Mitchell, but (1) demand for electricity and natural gas is almost certain to continue to rise, (2) Duke is generating enough cash from its internal operations to keep up a decent level of capital investment, and (3) the company's utility and gas businesses alone are worth $20 a share, and the stock closed Friday at $18.66.

• Martin Marietta Materials (MLM). This out-of-favor company produces aggregates (sand, gravel and the like) for heavy construction and road building. Investors have soured on the firm, driving its price down 40 percent this year, as government funding for transportation projects has been threatened by budget cuts and commercial construction has fallen off. But roads eventually have to be built and repaired, and Martin Marietta Materials, now at a P/E of 13 and a dividend yield of 2.1 percent, should rise again, say the Marshfield analysts.

• Washington Mutual (WM). The stock of the largest mortgage originator in the nation has been much more stable than the other two, trading in a band between $30 and $40 for nearly all of the past two years. But lately it has become cheap "because of investor concerns over lower net interest income, the possibility of an increased rate of defaults on mortgages" and worries over the use of financial hedging devices (meant to lower risk but sometimes having the opposite effect). "As is almost always the case with investor concerns, there is a large kernel of truth," writes Mitchell, "but we think the concerns are exaggerated." Certainly, earnings growth will slow as the refinancing boom fades, but Washington Mutual has the potential "to build a powerful, high-return franchise in its chosen segments." The stock trades at a P/E of about 9, based on this year's earnings, and carries a dividend yield of 3.2 percent.

Every one of these stocks has something wrong with it, but Marshfield is well aware of the problems and keeps a close eye on them. Where the firm makes its money, Mitchell told me, is "by arbitraging long term versus short term." In other words, a company like Washington Mutual may have short-term difficulties, which drive down its stock price, but in the long term it should do very well.

Sometimes Marshfield is wrong. "We kept our McDonald's [MCD]," admits Mitchell. "That was a mistake." The firm thought management would be able to overcome flabby product lines and recover. That hasn't happened, and McDonald's stock has fallen by half since the summer.

The firm likes another fast-food company, Yum Brands (YUM). Right now its KFC subsidiary is having trouble, but, says Mitchell, "they'll fix it, just as they did first with Pizza Hut and then with Taco Bell. This is a first-rate management." The poor KFC numbers drove the stock down by more than a third. "The market was displaying fits of pleasure when the stock was at 30," but turned on the company when it was at $20. Shares closed Friday at $22.64 for a P/E of a little under 12.

It's no surprise that Marshfield owns Berkshire Hathaway (BRK), the diversified holding company that Buffett chairs. "He's been buying private companies," said Mitchell. "That's where the value is." And Berkshire has $38 billion in bonds that it can convert into stock investments. Another favorite is a Berkshire-style insurance company, White Mountains Insurance Group (WTM), run by John Byrne, the former chairman of Geico (now owned by Berkshire). Mitchell calls White Mountains "a steal at these prices." The stock closed at $315.50 Friday, up $3 for the day but still down from the 52-week high of $379.50.

Unfortunately, the Marshfield principals manage money only for well-heeled individuals, foundations, hospitals and the like. They don't run a public mutual fund.

Who comes close to their style? Certainly, there's the superb Jensen fund (JENSX), which, like Marshfield, carries low risk ratings, holds stocks for the long term (average turnover is less than 20 percent annually) and has produced excellent returns (an annual average of 9.2 percent for the past five years). Jensen's top holdings, in a concentrated portfolio of 26 stocks, include State Street Corp. (STT), investment servicing and management; MBNA Corp. (KRB), credit card lending; Jones Apparel Group (JNY), women's clothes; Equifax (EFX), credit information; and Stryker (SYK), medical products.

Two other Marshfield-type funds are both longtime favorites of mine -- Dodge & Cox Stock (DODGX) and Yacktman (YACKX), both ranked in the top 1 percent of all funds for the past three years, according to Morningstar. Dodge & Cox favors huge companies that are out of favor with investors while Donald Yacktman, who had a spectacular year in 2001 (up 19 percent while the S&P was down 12 percent), looks for truly distressed properties.

But, despite their sterling records, all of these funds, just like Marshfield's private accounts, carry real risk. Dodge & Cox, for example, is down 14 percent for 2002 - its first losing year in more than a decade. Stock risk is inevitable, and all the green-eyeshade research in the world won't make it disappear. But risk-taking, ultimately, is a good thing - "essential," as Alan Greenspan, the Fed chairman has said, "to the growth of a free-market economy." And to the growth of every investor's portfolio.

 

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