Broker Check

Quarterly Newsletter October 2003

Quarterly Newsletter | October 2003

After a huge second-quarter move, equities survived a late September sell-off to post a solid third-quarter return. Smaller-cap stocks and foreign stocks lead the way with large gains. Investors who were paralyzed early in the year by fears of war and economic weakness learned that it is not enough to focus on risks; successful investing also requires assessing the degree to which the risks are already reflected in financial asset prices. When risks are regularly in the headlines, more often than not, investors’ worries rapidly drive prices lower, thereby pricing in some, all, or more than all of the risk. This lesson has been learned by generations of investors over and over again and underlies the mantra of never underestimate the ability of financial markets to surprise.

Isn’t The World Still A Risky Place?

The world always has been and always will be a risky place. It doesn’t take much effort to come up with a long list of economic and geopolitical worries that are troubling investors and citizens of the world at any given time. Sometimes the risks are greater than at other times but it is important to understand that the perception of risk is also volatile, and typically more volatile than the actual level of risk. This in turn affects valuations or, put another way, causes fluctuations in the level of risk that is priced into the financial markets. In March of 2000 nirvana was priced into financial markets—investors, collectively, were utterly unconcerned about risk. Conversely, in March of this year there was an above-average level of risk priced into stocks. But when the worst fears weren’t realized, stocks rallied and now, in my opinion, the financial markets are pricing in a middling level of risk—neither greed nor fear is in control.

So has the actual level of risk changed? Six months ago the three primary risks were:

  1. The risk that our valuation analysis could mislead us if investors’ risk appetites didn’t come back in the foreseeable future or if interest rates moved sharply higher.
  2. Structural problems with the economy and in particular high debt levels and the widening current account deficit.
  3. Geopolitical factors tied to terrorism and war with Iraq.

Most of these risks remain. So why have stock prices moved significantly higher? First, back in March investors were paralyzed by the potential short-term impact of the Iraq war. As the war progressed the concerns declined. Second, investors were concerned with near-term economic prospects. As profits experienced a sharp rebound, fiscal stimulus grew, productivity growth continued to impress, inventories worked lower, and corporate spending increased while consumer spending was robust, it became apparent that the economy was rebounding and, at least in the short-term, the risk of deflation or a return to recession was lower than it had been. Third, and perhaps most important, stocks and other equity asset classes were undervalued six months ago. This undervaluation was partly the result of the early year sell-off that was driven by war and economic fears. As these fears subsided stocks and other asset classes moved back to fair value. Yet, the longer-term risks remain.

We no longer need to be concerned that investors won’t rediscover their appetite for risk. That has happened, at least to an extent, as evidenced by the sharp rise in asset prices over the past six months. Now, with stocks and similar assets at fair value, the risk is that the margin of safety is gone.

Debt levels are still high and the question of what level is too high remains. The current account deficit is our biggest concern. It is driven primarily by our country’s massive demand for foreign goods (our imports are about one-and-a-half times our exports). The trade deficit requires us to make up for the shortfall with foreign investment. That’s been easy in the past because of the appeal of But there is a limit. Foreign investment in the U.S. has declined and the primary financing for the deficit has now come from Asian central banks—largely Japan and China— who have been motivated by a desire to keep their currencies weak in order to maintain strong U.S. demand for their exports. So this is a risk we need to be cognizant of and why it is important to hedge with exposure to foreign financial assets.

Geopolitical factors remain and are likely to remain for years. The threat of terrorism won’t go away and this is a wild card we must live with. Only certain kinds of terrorist acts would have a meaningful and sustained impact on economic behavior and financial markets. Whether terrorist acts that impact spending for an extended time period are likely to occur, it’s impossible to say. One thing that is clear is that the cost of the war on terrorism will have an economic impact over the long run to the extent it results in increased spending on activities that contribute less to long-term productivity.

In addition to these risks there is a new long-term risk on the radar and that is the risk of a gradual shift toward protectionist sentiment that could slow the growth in trade and the global economy. The collapse of the recent trade talks in Cancun, threats and pressure directed at China to adjust or float its exchange rate, still rising unemployment (which leads to pressure to protect domestic industry from competition), trade imbalances, and geopolitical tensions are, together, cause for concern on the trade front. Shifts in trade sentiment are unlikely to develop quickly but pose a longer-term risk.

So risks remain. We must also factor in potentially offsetting positive factors, such as the increasingly strong evidence that productivity growth has ratcheted up to a higher level in recent years. All of this must be weighed in determining what types of defensive hedges might be prudent and what diversification strategy makes sense.

Fund Research        

One of the important themes in my research involves looking for talented managers with small asset bases; not just small-cap managers, but managers of all styles. This has always been important, but with more good funds closing and others growing quickly, I feel there is an opportunity to identify talented managers more quickly before they are disadvantaged by size. The extent to which asset size impacts performance is easy to underestimate.


A small asset base can be a big advantage for a fund manager. Running less money enables a manager to get in and out of positions more quickly (since he owns fewer dollars of any particular stock, there is less market impact when he tries to buy or sell that stock). This isn’t always an important aspect of a particular manager’s process, but it gives him the flexibility to make decisions on his own timeline, rather than based on what the market allows him to do. A small asset base also provides a larger opportunity set: a small-cap manager could buy companies all the way down into the micro-cap universe (which is a less efficient market and is not as closely followed), and a large-cap manager can buy mid-caps (again, it simply gives him a larger number of names from which to pick). Also, since a manager doesn’t have as much money to get invested, he doesn’t have to spread it around as many names, enabling him to have a portfolio that is concentrated in his best ideas. Taken together, all of these positives can greatly increase a manager’s ability to generate superior returns.


The problem, of course, is that success begets success: as a fund does well (and assuming it does even a modestly good job of marketing itself), it will attract assets. Unless the fund company chooses to close its doors, eventually it will be running enough money that it will impact transactions costs (e.g., market impact, commissions, etc.) and reduce the above-mentioned benefits of being small.


For example, a small-cap manager has a handful of options as his asset base grows: own more names, hold more of each company’s stock, or own larger-cap stocks. A small-cap manager who is running $3 billion and has an average position size of 2% would own $60 million in each stock. This would constitute more than 10% of the shares of a $600 million market-cap stock. This could be a bigger or smaller problem depending on how much liquidity there is in that company’s stock, but in the vast majority of cases a manager would need several weeks—and possibly even a couple months—to enter or exit that position without influencing the stock’s price. Again, the magnitude of this problem is mitigated by a large number of factors, but it is a problem not faced by managers with smaller asset bases. This is part of the reason that a large or growing asset base can be a concern for a particular fund.


In all fairness, a large asset base can also confer certain advantages. A larger asset base should result in lower expenses. More assets also means more revenues, which in turn can be used to hire more and/or better talent (analysts), adding to both the breadth and depth of their research. And while some fund companies may choose to own more stocks as their asset base grows, others prefer to own the same number of stocks but take bigger stakes in the those companies (i.e., own a larger percentage of that company’s outstanding shares). As a large shareholder, the fund company likely receives better access to the company’s management and can take an activist role in maximizing shareholder value. In the end, though, I think that a smaller asset base usually creates the greatest opportunity for maximizing performance, and that is part of the reason I focus efforts on finding highly skilled managers who are not yet running a lot of money. Since the track record may be short, we may be required to append prior fund track records or separate account records to analyze performance.


Concluding Remarks

This past quarter was a sad one for the mutual fund industry. As you’ve probably read, New York’s attorney general filed a complaint alleging misdeeds involving several mutual fund companies. Though it does not appear that investors were materially damaged, the allegations (which are almost certainly true) are representative of a troubling lack of regard for shareholders on the part of the identified fund companies. We do not own any of these funds.

There is always a lot going on in the world and the markets, and the past several years have been especially dynamic. There are always many reasons for both concern and optimism, and new opportunities that are created from change. My goal remains to do careful research and make rational assessments of the opportunities and risks the markets present to us. Please contact me with any comments or concerns, or to schedule a review of your financial situation.

Mike Durant, October 2003