Dysfunctional investment practices

Watching the gyrations in the stock markets is ugly. Uglier still is watching my net worth decline! With the announcement of each piece of bad news comes a precipitous drop, followed by an unjustifiable spike as sentiment changes. The overall trend, unfortunately, has been down for a year.

All too frequently this thought comes to mind: "so what else is new?" Conditions have been parlous for a year so casualties could have been expected. It is only the identity of the casualties that should have been news.

This level of irrationality, demonstrated by market movements in the past few weeks, suggests panic, followed by euphoria, followed by more panic, as money managers rush around in ever diminishing circles and finally disappear up their own fundamental orifices.

The late Benjamin Graham, doyen of value investors, wrote the classic Security Analysis, first published in 1934. Mr. Graham proposed the idea of "Mr. Market", a manic depressive whose daily offers to buy your share of a business, or sell his share to you, were largely irrational. The good news is that there is no cost to ignoring Mr. Market: a decision to buy or sell can wait on the difference between the fundamentals and Mr. Market's offer. If Mr. Market is manic and offering far too much, then sell. Buy if he is depressive and asking far too little.

Competently executed, this style of investing can work really well. There is, however, one critical condition: value investors must have sufficient cash on hand to take advantage of Mr. Market's depressive phases. Unfortunately, the general market model has changed for the worse.

Most investments are now managed by institutions and the majority of those institutions offer mutual or exchange traded funds. This is the vehicle for the smaller investor - including 401(k) plan participants and IRA owners - to own the market or, allegedly, to benefit from the highly skilled efforts of professional money managers.

The first problem is the total reluctance of mutual fund managers to hold cash. Anything more than needed to cover the normal level of redemptions appears to be effectively prohibited. So, when panic strikes, the managers are forced to raise cash by selling into a declining market. When everyone is trying to get out at the same time, the result is a rapid decline in share prices.

The converse is that, when markets are rising, a flood of new money arrives and the culture forces mutual fund managers to buy high. "Buy high, sell higher" is known as "momentum investing" and can be very profitable if an investor can consistently and accurately call the top. Once at the top, the strategy is to sell like crazy, but a requirement to stay fully invested prohibits that.

The second major problem is that mutual funds simply do not hold enough cash to take advantage of the times when Mr. Market is severely depressed.

The mutual fund model is broken. Without the ability - or even the will - to sell and then hold very substantial cash balances when share prices are far higher than the fundamentals justify, the market is trapped in a positive feedback loop. The result is increased volatility and, depending on the direction of prices, euphoria or panic - often succeeding each other in rapid succession.

I am a limited partner in a small private equity (leveraged buyout or LBO) fund. So far, in a little over two years, the managers have drawn 40% of our capital commitments while returning capital and dividends equal to nearly half of that. They are in no rush to spend the rest of our money but, on a day when Mr. Market is more than usually depressed, there is plenty of cash available to take advantage of the opportunity.

The biggest difference between LBO and mutual funds is that we, the LBO fund investors, are along for the ride. We have no exit until the fund's life comes to a natural end: no matter how much we panic, we are unable to force the manager to sell into a declining market.

The incentives of private equity fund managers are well aligned with those of the investors. The model is functional and all that the investors need is a manager with a proper understanding of value - and the discipline to refrain from either overpaying or burdening the portfolio companies with excesive debt. While private equity carries higher than average risk, the returns are also likely to be higher than average. More important is the fact that returns are primarily linked to the skills, and discipline, of the manager and less affected by a mutual fund manager's inability to ignore the day to day irrationality of Mr. Market.

To say that the current investment model is irrational and dysfunctional is one thing. It is very likely an accurate statement but investors are well advised to consider this thought from the late economist Maynard Keynes:

"The market can stay irrational longer than you can stay solvent."