Completion Analysis: Fuller Picture - Weekly Blog # 560

by: Mike Lipper, CFA
Summary

One of the first things I learned as an analyst selling sell-side research conclusions to a skeptical institutional audience were the negatives to my viewpoint or at least the contrary facts.

This blog will discuss the other side of two very popular items in the popular and professional press, Saint Jack Bogle and the celebration of high return on equity and operating profit margin.

In summary, I have great respect for Saint Jack, the mutual fund business's Don Quixote.

One of the first things I learned as an analyst selling sell-side research conclusions to a skeptical institutional audience were the negatives to my viewpoint or at least the contrary facts. Often when I thought I had a sound point of view I would arrange a week of visiting mutual funds and other institutions in Boston. In many respects, this was an intensive course in the analysis of both more facts to consider, including the points of view of more knowledgeable analysts from the vantage points of their portfolios. By the end of the week I had a much fuller understanding of my own views. Further, I made up my mind that I should not consider a sales pitch until I was familiar with the opposite point of view. Thus, for me and those who eventually worked with me, I insisted on learning and using a more complete picture or as complete an analysis as possible.

With that as an introduction, this blog will discuss the other side of two very popular items in the popular and professional press, Saint Jack Bogle and the celebration of high return on equity and operating profit margin.

"Saint Jack"

Jack's high intelligence and high intensity appealed to the CEO of Wellington Management, then located in Philadelphia. At that time Wellington was a load fund group relying on good wholesalers to convince retail brokers to sell the Wellington Fund and its new and much smaller, all equity and value-focused, Windsor Fund (managed by the great John Neff). Walter Morgan decided it was politically smarter to name Jack president, rather than one of the competing sales people. At that time fund buyers were more interested in investment performance than the relative safety of the Wellington balanced fund, which was losing market share in the fund business. Jack trusted numbers more than people. He was taken in by the advocates of Modern Portfolio Theory (MPT), which in truth was not modern, not a portfolio theory. Nevertheless, Jack had urged the SEC to require alpha and beta numbers to be required in fund prospectuses. Luckily, even with the endorsement of the CFA Institute, the SEC, some recognized that these numbers were history and might be used to make poor decisions. Jack was determined to get Wellington moving again.

Accelerating growth was the rage at the time and Jack engineered a deal with a Boston manager of growth funds. The deal gave the acquired control of the merged company in a ten-year voting trust. I was visiting Jack either on the day the announcement was published or very soon thereafter. He was pleased with the deal. I cautioned that he might have lost his company. Thus, I was not surprised when he was removed. (By the way, this follows a long tradition of an antipathy between Boston and Philadelphia, since the American Revolution.)

Jack was always resourceful, from his scholarship days at Blair Academy through Princeton. He recognized that while he had lost control of the investment advisor, the independent directors of the mutual funds remained his friends. He convinced them they should internalize the operation, like many closed-end funds in the US and Investment Trusts in the UK. The idea of investing in a passive market vehicle was not new. Since at least the 1940s, the Founders Mutual Depositors Fund had been a UIT invested in the 40 largest companies in the Fortune 500. I believe there were several UK Investment Trusts that had similar strategies.

What particularly appealed to Jack was that by going no-load he was materially reducing the power and presence of the sales people. He had the view that they were just a bothersome expense. There was never a study done as to the value of the sales people. (Having known many of them over the years, I suspect some were good and provided both good advice and service to investors.) Jack was a very good student of the mutual fund industry and what he saw as a benefit for Vanguard was the difference in Total Expense Ratio (TER) between an index fund and an actively managed fund. While a lower fee was a plus, what probably aided performance more was that index funds were fully invested in the market and did not have a built-in redemption reserve. Most active funds have up to 5% in cash to meet redemptions and opportunities. By getting these reserves committed, all of the investment was working for them in rising markets. When markets went down, which happens a minority of the time, active managers holding cash can outperform. This advantage also persists in the early phase of recoveries. For example, the average S&P 500 index fund was up +5.22% in the first 17 days of 2019, compared to the average US Diversified Equity fund which gained +6.22%. There were other advantages for index funds, the first is that when dealing in size, active funds may have knowledge of something of upcoming importance. To protect themselves the dealers who were providing liquidity to these funds, wanted a wider spread in their favor. Index funds convinced the marketplace that their trades were without information value and that there was no need for a wider spread. There were also administrative expense savings possible.

While this numbers-oriented pitch would have appealed to Jack, there were some sales aids that were also of great help. The first is that New York State in the 1940s permitted the Teachers Investment Annuity Association (TIAA) to sell the College Retirement Equity Fund (CREF) to college professors. For many years the bulk of CREF was indexed. Many Professors had proven to themselves that they were poor investors and therefore didn't trust the market. When Vanguard's group of institutional sales people discovered this, they had found a fertile field of investors at both educational institutions and foundations. The benefits of indexing were taught at lots of schools, without giving a fuller understanding of investing or indexing. Many of today's media pundits were educated in these incomplete classes.

In summary, I have great respect for Saint Jack, the mutual fund business's Don Quixote. He brought a number of important issues forward, but his motivation was not as pure as is being memorialized. We do use index funds within our managed accounts when we cannot find better actively managed funds at a reasonable cost.

High Number Celebrations

We are probably at the crest of the current economic expansion. As has happened in the past, markets can decline while the general economy remains in expansion. However, one of the functions of a prudent investor and manager is to be on the watch for signs of trouble ahead. During this season of reading annual reports and conference call pep-talks, one should be looking into the celebration of big numbers. As an analyst I pay little attention to reported earnings, as they have been adjusted by favorable accounting moves or management's focus on what is working now and avoiding what is not, which is more difficult to spot. While I look at many ratios, the three that are the most important to me are return on equity (ROE), operating profit-margin, and net cash generation after debt service.

This season I am seeing record results reported for ROE. In one case, a net interest earner reported average ROE at an annualized 20%. This is being created by shifting client assets into more favorable earnings for the organization and there isn't a great deal more to go. The 20% number reminded me that before the Bogle impact and other structural changes, members of the NYSE could attract general and limited partners based on a 25% return on partner's balances. These firms were not particularly special in terms of skills so I declined to join them, which saved me from several failing firms.

One of the lessons coming from a recent experience with Apple (*) (NASDAQ:AAPL) is the danger of showing high profit margins based on high prices. In effect, Apple is holding out an umbrella over competitors in order to use price competition to successfully take market share at lower levels of profitability. Apparently, investors are expecting revenues to grow slower than they were in 2018, but sufficiently enough to be acceptable. I wonder whether a 1% slower revenue growth will lead to a 1% decline in either profit-margin or ROE. Instead of 1%, a 3% or 5% revenue decline will have a more serious impact on the ratios, as operating leverage works both ways.

After four favorable weeks of US stock market performance we could be slowing down in the recovery, even if the three major stock indices appear to have gotten over their 65-day moving average. I continue to wonder, even with bouts of enthusiasm in between, whether 2019's average performance results will be in single digits, similar to their first full week's performance. By the way, the AAII sample survey has all three choices in the 30% rage: bullish, neutral, and bearish.

Thoughts?

*Held in personal accounts

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.