IHAVE BEEN managing other people's money for some 36 years. The first third of that period was spent with a national investment council firm primarily managing individual portfolios. The latter two-thirds was spent with my present organization which manages some $15 billion or so of institutional accounts, primarily corporate and public retirement funds.
I can make a couple of observations about the past week's "crash" (if that is the right word).
The downside risk in this market -- the direction, but heaven knows not the extent -- has been plainly visible for some.
The general level of the market now -- around1,800 to 2,000 on the Dow-Jones Index -- is where money managers generally believe it belongs.
And, finally, although the underlying values in the economy look sound, all bets are off if consumers, believing that hard times are coming, begin acting that way and precipitate a self-fulfilling prophecy.
If I, and others like me, thought a crash was possible, why didn't we do something sooner? The reason that such a widely discussed, visible risk was not acted upon by more professional money managers has to do with the nature of institutional money management, which dominates the world's equity markets today. Institutional money management is measured much more in relative than in absolute terms. For better or worse, more institutions measure (and hire and fire) their money managers not so much by whether money has been made or lost as by whether their portfolios have gone up more than the market or gone down less.
A money manager who has lost 25 percent of his clients' money in a market that is down 30 percent has done a brilliant job. For a money management organization, the rewards of a performance better than the Standard & Poor's 500 are enormous. The penalties of a performance less than the S&P 500 are quite painful. As a result, no money manager with an IQ as high as his body temperature is going to bail out of a rampant bull market, whether or not he thinks stocks are overpriced.
Money management is a business where being right early has usually the same consequences as being wrong. Most concerned and thoughtful money managers do not bail out of the market when they're worried. Rather, they build up cash positions of 10-15 percent. This practice allows them to stay close to a roaring bull market, but stands them in good relative position should the market fall into a black hole.
Nonetheless, the indicators were clearly there that the market was overpriced. From the beginning of 1987 through September 30, stock prices advanced almost 40 percent, while long-term U.S. Treasury bonds declined 25 percent. This change resulted in stock dividend yields that average about 2.7 percent and bond yields of about 10 percent -- roughly a 4-to-1 ratio. The normal relationship of bond yields to stock yields that money managers look for is on the order of 2-to-1. No one (even those of us who had been around 36 years), had ever seen a market in which long-term United States Treasury bonds provided a yield almost four times that of the Standard & Poor's 500 stock index. Despite the prospect for sharply higher corporate earnings in 1987 and 1988, the relationship between bond yields and stock yields just did not make sense.
A market that is off over 20 percent in one day and almost 25 percent in two trading days is unprecedented, but it is not the end of the world. The critical question is "where do we go from here?" It seems to me that the market in a range of 1,800 to 2,000 on the Dow Jones Industrial Average looks about right. Based on the prevailing consensus prediction that corporate earnings will be up nearly 25 percent in 1987 and perhaps another 20 percent in 1988, the equity market today is reasonably attractive in relation to long-term Treasury bond yields of 10 percent.
However, all pronosticators have a caveat. The decline of the past week or so has resulted in the loss of more than half a trillion dollars on the asset side of America's collective balance sheet. Who knows how this event will affect individuals in their decisions to buy a new car or a refrigerator or a fur coat or a cruise trip to Alaska? Who knows how it will influence businessmen about to order a new data processing system or to build a warehouse or to hire four new salesmen?
My guess is that if the market holds around current levels (off some 25 percent from its high), these kinds of consumer and business decisions will be made cautiously but not so as to stifle future economic growth. In order words, I do not think we are headed into a 1929-style depression period.
As an equity portfolio manager, I have always tried to focus on two things: risk and value, particularly value. It hardly seems conceivable that this is especially unique. After all, what kind of an investor would you be if you did not focus on "value". Believe it or not, however, the many pension fund consultants across America have put "value investors" in a separate category. And its not on especially large category.
Being a value investor is not very complicated. It does not require a computer or a PhD All you have to do is ask yourself when you are contemplating the purchase of 100 shares of a stock, "Would I buy the whole company if I could get it at this price?" When you buy a 100 shares of stock, you can always hope that no matter how absurd a price you pay, there is always some "greater fool" out there who will be willing to buy it from you at an even higher price.
If you own the entire company, the chances are pretty good that you will have to rely on the internally generated profits of that company to achieve whatever investment gain you hope to obtain. If you buy a company at 50 times earnings, and you own the whole damn thing, the company is going to have to grow like spook, or you are going to have to live to a ripe old age, to beat the kind of return you could get by putting your money in Treasury notes. Value investing is easy. Anyone can do it. All you have to do is ask yourself is, "am I likely to get an attractive rate of return on this stock if no greater fool comes along and I have to hold it for 5 or 10 years?"
Successful investing is not hard. Many of my most successful personal investments have resulted from looking at the manufacturer's label of some product I purchased and found to be unusually effective.
Sometimes you find those products are made by some new publicly held company. It is not a complicated process. If you really like the product, buy the stock -- unless it is clearly over priced. One of the greater misconceptions of our time is that a thoughtful individual cannot compete with a professional research department of 25 or 30 bright-eyed, bushy tailed MBAs from the leading graduate business schools. Most individuals have unique expertise in some particular area that allows them to make some superior investment decisions.
The biggest mistake made by most individual investors is in expecting that the market will be rational. Most individual investors believe that "the market" knows more than they do. Nothing could be further from the truth. I have a giant sign on my office wall that says, "Fear and Greed". In the long run, earnings and dividends determine the value of publicly owned corporations. In the short run, however, it is those old-fashioned emotions "fear and greed."
In the short run, "value" doesn't matter. John Maynard Keynes said it all when he observed that if an individual investor has a preference for liquidity, "value" is irrelevant. A frightened potential buyer may decide not to invest no matter how attractive the investment. Since Keynes' observation, individual investors have been replaced by institutional investors. However, nothing else has changed very much. On a day-to-day and week-to-week basis, stock prices are still determined by greed and fear. Rarely is the nervous investor a successful investor. Those who achieve superior results over time do not see themselves as owning a paper stock certificate but as partner is a business. It sounds corny, but it's true.
The question many individuals are asking themselves today is "Should I begin to invest my savings in common stocks?" In my opinion, this a probably a pretty good time. Stocks are not particularly cheap, but they are good values. Quality stocks like IBM, General Electric, J.P. Morgan, Johnson & Johnson, and the like are down one-third or more from their highs. Most individuals would probably be better served by investing in a mutual fund that concentrated in quality blue chip stocks rather than trying to pick individual issues.
However, if by investing now, the individual is trying to "catch the bottom," he had better wait. This is an emotionally-charged period in the financial markets. Just because stocks represent good value does not mean that holders are going to stop selling them, and buyers are going to begin buying them. If you like the future potential earnings and dividends growth from a stock like IBM, go ahead and buy it. If you need to be sure that you can sell it to someone else at a higher price three or six months from now, you probably better forget it.
Robert Kirby is chairman of the board of Capital Guardian Trust Co., a Los Angeles firm that manages institutional portfolios.