Mr. Buffett, Your Time Is Up (Worth Article)
by Adam Hanft September 2001, Worth magazine
Buy-and-hold investing was never as smart as Warren Buffett made it look. Today the strategy may even prove dangerous to your porfolio.
Good things come to those who wait. Better a tortoise than a hare. Don't be greedy. Avoid temptation. Patience is a virtue.
These are our moral sound bites, an American song to the rightness of shunning the quick hit. These lessons have been imprinted on us by everything from Poor Richard's Almanac to the harsh guidance of myth, religion, and fairy tales. And with investing as our new secular faith, these precepts have begotten their own religious denominations. We pray at the altar of Value Investing and Long-Term Investing, worship the sacred principle of Know What You Own, and bow down before Buy and Hold. Being human we sometimes stray--the latest transgression being the worship of the golden calf of technology, for which we have been suitably punished. Chastened, we have returned to scripture: Surveying the Nasdaq wreckage, we vow never to doubt blue chips and conservative mutual funds again.
Is that the right response? Conventional wisdom--as spouted by investment banks, financial experts, and other opinion retailers--insists that it is. Now, however, is the perfect time for a deeper reconsideration that asks if the idea of long-term investing might be just as flawed (although clearly not as likely to lead to disaster) as the reasoning that compelled people to buy Priceline at $165 (an elevation it hit at a particularly euphoric moment on April 30, 1999). What if riding out market volatility with so-called good companies is another kind of casino investing and the so-called flight to safety is a rush toward another kind of risk?
No one has done more to sanctify the principle of buy and hold, even in the face of struggling performance, than Warren Buffett. He is the ultimate leave-with-the-girl-you-came-with guy, and given his standing as one of the richest men in the world, it's hard--but not impossible--to disagree with him. In the most recent annual letter of Berkshire Hathaway, the company through which he and longtime associate Charles Munger do their investing, Buffett remains Buffett: "Charlie and I hope that you do not think of yourself as merely owning a piece of paper whose price wiggles around. We hope you instead visualize yourself as a part owner of a business that you expect to stay with indefinitely, much as you might if you owned a farm or an apartment house in partnership with members of your family." This homespun philosophy is straight from an era when marriages stayed together for the kids, when you had one job for life. And therein lies part of the rub. As Credit Suisse First Boston warned in a report last December, "Whereas a generation ago, the market could reasonably assume that a company could sustain a franchise for a long time, such assumptions are not realistic today."
If Buffett helped burnish buy and hold to its current sheen of virtuous wisdom, the tax code helped institutionalize it. The moral superiority of long-term investing has been plaited into our tax structure since the Revenue Act of 1921 introduced different, and differently taxed, holding periods. Although it has often been modified, the didactic--punish the short term, reward the long--has remained consistent. Writing in the Washington University Law Quarterly, Stuart Banner notes that "as long as securities have been traded, Anglo-American popular culture has contained a few strands of thought suspicious of trading and hostile to speculators."
The received wisdom of long-termism has fostered an investing amnesia that makes it easy to dismiss long periods of sideways motion during flat markets and encouraged an investing bravado that overstates the wins during bull markets. Case in point: Market optimists in the late 1960s had to wait until the early 1980s for their portfolios to recover. (Long term, or suspended animation, Wall Street style?) Nor is that recovery based on static parameters. Market calculations favored by buy-and-holders rely on the changing composition of the Dow Jones and the S&P 500. (Five of the top 15 S&P companies weren't even on the S&P 20 years ago.) If leading indexes don't select and hold, why should you buy and hold?
Buy and hold may not even be the best approach in the best of times. The recently flamed-out longest-running bull market in history had more than its share of examples in which a buy-and-hold strategy--even with serious growth companies--would have yielded only middling success. Consider a hypothetical 1993 portfolio that included Motorola, GM, and Coca-Cola. Sounds like a classic long-term approach, does it not? Motorola had reinvented itself as a telecommunications player poised to take advantage of the global cell phone revolution. Coke, a Buffett favorite, was the ultimate global consumer brand. And GM had reengineered its manufacturing and rehabilitated its reputation for quality, and stood ready to capitalize on the coming car-buying years of high growth and low unemployment. But had you allocated $100,000 evenly among those stocks at the bull's very start in 1993, you would have accumulated a modest $189,280 by April 30, 2001, a compounded annual return of 8 percent. Not shabby, but considering the risks and the market's overall performance, not sterling.
It's simplistic thinking, this idea that a small group of high-quality stocks can become a sort of perpetual motion machine of investing. Buffett says about his companies, "We would not care in the least if several years went by in which there was no trading," but his own recent behavior in the case of Gillette (more on that later) belies this claim. Long-term investing was never a bulletproof growth strategy, and its inherent flaws are all the more dangerous in today's economic environment. Here are 10 reasons:
Long-term investors should think of it this way: The sole purpose of those billions of available dollars in venture funding is to decimate the status quo.
1. An accelerating rate of change means accelerating risk
Entrepreneurship and innovation are shocking so many industries so fast that even the best companies will be hard-pressed to maintain continued growth and market dominance. (Intel can be considered the Poster Equity of this trend.) Economist Joseph Schumpeter, best known for his concept of the "gale of creative destruction," argued that the introduction of market-altering technologies--he analyzed steam, rail transport, and electricity--spurs a burst of industries that exploit the new tools, producing "long waves" of economic growth.
Nineteenth-century long waves were truly long: They created decades of consistent opportunity. But today's waves are speeding up, bringing on ever-faster cycles of innovation. Clayton Christensen, a professor at the Harvard Business School, updates Schumpeter in his 1997 best-seller The Innovator's Dilemma. Christensen's theory of "disruptive technology" identifies an Achilles' heel of long-term investing: He argues that the very characteristic that makes today's leaders successful--an obsession with the current needs of their best customers--distracts them from a necessary focus on the future. Thus, the longer a position--any position--an investor holds, the greater the chance the investor will be blindsided. By what? By the x-factor, the portfolio-wrecking monkey wrench, the surprise that crawls out of the primordial soup of the entrepreneurial economy and becomes the nightmare of even the most boring of all businesses.
Buffett describes Berkshire's acquisition candidates as "simple businesses (if there's lots of technology, we won't understand it)," but the truth beneath the charm is that today, there are no simple businesses. Complexity is inevitable, and so is surprise.
2. The company you've bought may not be the company you own
Thrown into a spiral of fear by all these risks, companies are reinventing themselves with a frenzy; indeed, a firm that doesn't boast that at any given time it's "reexamining its business from the ground up" runs the risk of being perceived as an ostrich. Investors can go to bed thinking they own a company in one industry, only to wake up and find that they have invested in an entirely different business model. Gulp.
Sometimes reengineering works; witness Enron's successful transformation from a yawn-yawn utility to a dynamic creator of dynamic marketplaces. But sometimes it doesn't, as in the slow destruction of the valued Aetna brand. Once a respectable insurance name, Aetna turned itself into an HMO and then merged with U.S. Healthcare. Eventually, Aetna was forced to surrender its corporate gem--its financial services division--to ING for a fire-sale price. Similarly, the morphing of AT&T into a confused, multiplatform, cable-enriched telecom has left investors scratching their heads.
Switching business models in midstream makes a mockery of one of the basic tenets of buy and hold: Stick with companies that are consistently executing a clear business vision. Yet with consultants from Tom Peters to Michael Porter exhorting companies to be nimble enough to switch strategy gears overnight, investors have a new responsibility: assuring that the company they're holding remains the company they bought.
3. You don't lead a buy-and-hold life
Buy-and-hold advocates recognize that there are inevitable periods of market drift and decay. Wait it out, they say. For more of us, more often, that isn't realistic.
When the trajectories of our lives were more predictable and our needs for capital came on cue, we may have had time to catch up with a decade or so of market drift. But we can't afford that anymore. We lead nonlinear lives. Some investors might be quitting their jobs and starting businesses at 35, others might be emerging from phased retirement (the latest trend) and starting businesses at 63. Others might be adopting a baby at 60. If your long-term hold is out of rhythm with your short-term life, you're in trouble. An investor who bought IBM at $44 on August 21, 1987, would have had to wait until May 13, 1997, for it to hit $44 again.
4. Anyone can get in
Information technology, the Internet, and the global supply chain have lowered the barriers to entry in virtually every business. Competition is accelerated as new companies arise to challenge market leaders. Check out Linux, the new open-source operating system. Red Hat, the leading Linux public company, has had its problems, but its annual report has every right to ask, "Is it any surprise that a free operating system created in 1991 by a student now runs more than a quarter of all new servers?"
Much has been written about how far you can get with a pile of credit card loans and the way in which e-commerce flattens entry barriers. It's all true. Corporate establishments shouldn't take much solace now that so many e-tailers have tripped over their own feet. The Internet forever changes the distribution picture.
Further, for a long time, it was believed that "switching costs" (the economic burden of shifting platforms) and "network effects" (the benefits that accrue to a user when a technology is widespread) insulated market leaders. But recent research shows otherwise. The FTC's Office of Policy Planning recently issued a report titled "Application of Competition Policy to High-Tech Markets." It found that a new competitor with proprietary technology can use "penetration pricing, i.e. below-cost pricing at the beginning of a technology's life [to] displace an incumbent despite the presence of network effects." The same report shows that "network effects yield not a first-mover advantage but a second-mover advantage." Second-mover advantage is not what a long-term investor wants to hear.
Even in capital-intensive manufacturing, barriers to entry are lowered by new technologies that erode long-established insulation. (It can actually cost less to build a new state-of-the-art factory than to retrofit an old one.) Writing on the aeronautic industry, the Office of Science and Technology Policy (an analytical group reporting to the executive branch of the federal government) says that new methodologies have "lowered barriers to entry into, and increased competition in, the industry." It cites reductions of 30 to 50 percent in the time and cost required to design, develop, and produce new aircraft. If airplane building can become a more competitive marketplace, then no category is spared from the jolt of the new.
5. More money for many, more problems for some
Cocky senior managers were once inoculated by the difficulties that insurgents faced in finding financing. It was a structural insurance policy. An old-boy, risk-averse capital-raising apparatus allowed mature companies--even those with blinded leadership--to continue to reward long-term investors. No longer. An environment that protected incumbents has become one in which breakthrough ideas, when commanded by serious management, can get funding. Venture capital, whether from pension funds, investment banks, or other great pools of cash, is sloshing around the economy, looking for innovation. No market leader is safe. The sole purpose of those billions of available dollars in venture funding is to decimate the status quo.
6. "The same job for the rest of my life? Hell, I don't even want the same life for the rest of my life."
Market-leading companies are complex entities dependent on management talent, and plenty of it. Long-term investors aren't sinking their bucks just into a smart CEO, a cool business model, and differentiated technology but into hundreds (if not thousands) of individual leaders in sales, marketing, research and development, and corporate strategy. The chances of keeping this talent pool within the company is increasingly unlikely because of multiple seductions: starting a business, becoming a stay-at-home parent, jumping to a competitor, and consulting, to name just a handful. Frederick F. Reichheld's provocative book The Loyalty Effect: The Hidden Force Behind Growth, Profits, and Lasting Value has noted that a majority of U.S. corporations now lose half their employees in four years. The implication for long-term investors is harrowing. (This is an area that most analysts overlook: Other than the obligatory "Worldwide Widgets has a strong management team in place," how many research reports assess intellectual capital with between-the-lines insight?)
Buffett, in his 2000 annual report, alludes gently to the brain drain by denying that the companies he invests in suffer from it: "At Berkshire, our all-stars have exactly the jobs they want, ones that they hope and expect to keep throughout their business lifetimes. In our last 36 years, Berkshire has never had a manager of a significant subsidiary voluntarily leave to join another business." Come now, Warren. Do you really think you'll be able to hold on to your best in the years to come? Good people want new challenges. Itches need to be scratched. Entrepreneurial sparks need oxygen. And that's particularly true in the low-technology industries you pride yourself on investing in. Indeed, in the same annual report, you tweak the new economy by writing, "I will tell you now that we have embraced the 21st century by entering such cutting-edge industries as brick, carpet, insulation, and paint. Try to control your excitement." Every indicator is that it's going to be tough to satisfy the best and the brightest with bricks and insulation.
7. History doesn't repeat itself
Consider recent developments at Gillette, a long-term Buffett favorite; Berkshire Hathaway holds 9 percent of the stock. Longtime CEO Alfred Zeien had shaped Gillette into the model of a global high-growth consumer-products company. So successful was he that the board didn't let him hit the golf course as scheduled, and he continued to perform superbly: In January 1997, Business Week noted, "Two years ago, Gillette directors raised eyebrows by letting CEO Alfred M. Zeien stay past the mandatory retirement age of 65. Shareholders are happy they did. Under Zeien, Gillette has racked up 25 straight quarters of double-digit earnings gains. And 1996 was no exception. As Zeien extended Gillette's global dominance in the shaving business and pulled off a $7.7 billion buyout of battery maker Duracell, its stock rose nearly 40 percent."
Zeien's successor, Michael Hawley, seemed poised to continue Gillette's march. He was an experienced manager whose greatest claim at Gillette was that he had helped spearhead the company's global expansion. Hawley's stint, however, was fraught with problems, and the company's earnings went south. He was quickly forced out by none other than that patient sage of Omaha, Warren Buffett. ("Gillette honcho nicked by board member Buffett after just 17 months" said one headline.) The new CEO, James Kilts, was brought in to dress up this icon of long-term investing for sale. If it can happen to Gillette, it can happen anywhere.
8. The experts bailed out of long-term investing ages ago
If long-term investing is such a good idea, how come the pros don't practice it? The Mutual Fund Tax Awareness Act of 2000 noted, "The average portfolio turnover rate for an actively managed (nonindex) fund has increased from 30 percent 20 years ago to almost 90 percent today." Why were legislators concerned about turnover? Because of the stealth capital gains implications that lurk behind advertised rates of return. Turnover can create unexpected tax liabilities in down years such as 2000, when thousands of investors owed taxes on profits that were realized before they had bought their shares. So they had to pay a tax bill on investments that tanked.
"A buy-and-hold investment style designation is not justified when the turnover rate starts to exceed 20 percent," says the National Association of Investment Clubs. That eliminates just about every equity fund except the Snooze Horizon Fund. Portfolio managers have become short-term fiends, trading at an increasingly fast and furious pace. Yet the Street continues to advise the public to do just the opposite.
9. We inhabit a culture of impatience
The wider world is working (and rushing) against buy-and-hold investors. In a revealing experiment, researchers in New York City and London asked people on the street how long it took for 30 seconds to elapse. In New York, nine out of 10 people "significantly underestimated" the passage of time. Eight out of 10 Londoners did the same. Twenty percent of the New Yorkers believed 30 seconds had flown by in less than 15.
Our speed addiction is changing everything, from the way we eat (approximately 20 percent of all meals are gobbled in cars) to the way we process images (the average number of shots in a TV commercial has gone from 7.9 in 1978 to more than 14 today) to the way we invest. Market volatility is, in many ways, a self-perpetuating phenomenon. If sellers rapidly lose faith, the buy-and-hold sucker can be left holding on to a portfolio of leisure suits while the amphetamine investor has moved on. As The Loyalty Effect points out, most public companies lose half their investors in less than a year.
10. Big...companies...grow...slowly
The bulking up of our largest businesses is striking. The 25th largest company on today's Fortune 500, Merrill Lynch, would have been, at its current $45 billion in sales, No. 7 on the list for 1991. Global companies this large are bound to suffer from a kind of living rigor mortis. Some divisions and subsidiaries will suffer while others flourish. Virtually all companies are dependent on foreign economies that might move parallel with our domestic economy and, then again, might not. Many giants are recent creations--mergers of companies with individual track records--or tactical spin-offs (Agilent, Avaya). An unproven record of growth hardly sounds like a foundation for long-term confidence, but such is the history-less (and generally unacknowledged) nature of most modern blue chips.
Even Buffett has acknowledged of his clutch of companies, "The best rate of gain in intrinsic value we can even hope for is an average of 15 percent per annum, and we may well fall far short of that target.... [V]ery few large businesses have a chance of compounding intrinsic value at 15 percent per annum over an extended period of time."
One by one, the props that support the long-term argument get kicked out from under it. Kick out enough of them, and the rate of corporate mortality rises--which is precisely what's happening. CFSB notes that "the average life' of a company in the S&P 500 today is less than 15 years, dramatically less than a half century ago." Arie de Geus, in his book The Living Company: Habits for Survival in a Turbulent Business Environment, demonstrates that "the average life expectancy of a multinational corporation is between 40 and 50 years." On average, businesses die before their shareholders.
So what's an investor to do? Certainly not return to speculation or, God forbid, day trading. We need to develop a new approach--call it right-term investing--that recognizes the realities of unexpected change, truncated corporate life cycles, and all the other risks. Right-term investing isn't about timing the market or even a sector; it is about company timing, and syncing your life with the performance arc of your portfolio. Right-term investing, essentially, is what the national guru Peter Lynch had in mind when he advised investors to "write down on a piece of paper why you're buying [a stock], why you think the company's going to do well. And as time goes on, keep checking the story. As long as it's a true story, you hold on to the stock." Still, back in 1993, when Lynch wrote Beating the Street, he couldn't have expected that so many stories would change so quickly.
We need experts to devise new ways of looking at our portfolios. This should include a set of analytics to help us map where a company stands in its life cycle and how its prospects intersect with investors' upcoming needs (sending kids to college, funding a business, buying a second home). Is a company in its infancy? Its adolescence? Or is it tottering toward corporate geezerhood? (These indexes and metrics would complement earnings multiples, debt-equity ratios, and other traditional measures.) Analysts also need to work harder to understand the process by which businesses age, incorporating the work of such thinkers as Ichak Adizes, author of Corporate Life Cycles: How and Why Corporations Grow and Die and What to Do About It.
There are indications that the idea behind right-term investing is gaining traction. A best-selling book called The Gorilla Game: Picking Winners in High Technology makes the argument that only one or two "gorillas" will end up dominating each technology segment. Authors Geoffrey Moore, Paul Johnson, and Tom Kippola advise investors to start with a diverse portfolio and drop the weaker primates until they're holding only the gorillas.
For the most part, though, stockbrokers continue on their same suicidal march. Consider Merrill Lynch's useless "Theme Profile Investing Update" of May 2001, which instructs those seeking "long-term growth" to focus on the "basic engines of change," which are globalization, the technology revolution, demographic change, and productivity enhancement. Given the specific realities that shape any company's destiny, how can such sweeping characterizations be anything but misleading?
It's going to be tough for many investors to break the habits of the bipolar world they inhabit, where they bounce from wild impatience (selling a stock too early) to buy-and-hold stubbornness. Right-term investing will demand a higher level of portfolio attention than investors have needed, or exhibited, before. That doesn't mean hours of ticker watching, but it does require a change in thinking. More important than the state of the market, or the sector, is the state of each holding. Each company is on a journey to its own demise, and in a world where corporate immortality is no longer a given, it will be only a matter of time before you won't want to go along for the ride anymore.
Adam Hanft is co-author of The Dictionary of the Future, to be published soon by Hyperion. |
