3.3.13 Stock Picking Gurus and Their Real Records

The dangers of stock picking become crystal clear when we focus on the best, brightest, and most famous stars of the investment industry. (More Bad Bets and Big Losses)

Jack Grubman was touted as king of the telecom stock industry in the mid-to-late 1990s. As Salomon Smith Barney’s appointed telecom analyst, Grubman was regarded as the most influential power broker in the industry. He was rated number one in Institutional Investor’s annual analyst rankings and was profiled by The Wall Street Journal, BusinessWeek, and New York Magazine. When Grubman talked, people listened. If he said, “buy,” people bought; if he said, “sell,” people sold. One broker likened Grubman’s advice to a narcotic. Everybody wanted it. Salomon Smith Barney’s 13,000 brokers passed along his stock picks to their clients. His many monikers included, “Telecom god,” “Consigliore,” and “Ax.” At the height of the telecom industry, he gave advice on 40 stocks with a combined market value of more than $1 trillion. He himself made $20 million a year.

Most everyone knows the rest of the story. The glamorous telecom sector soared beyond imagination, and then went bust with enormous consequences. Grubman’s top 10 picks in March, 2001, all plummeted to the lowest of lows a year later. As of May 2002, five of the 10 were trading under $1 a share. Three of the 10 had filed for bankruptcy including Global Crossing, McLeodUSA, and Winstar Communications. Along with the Global Crossing bankruptcy went $55 billion of paper wealth down the drain.

Investors lost millions relying on Grubman’s supposed wisdom. The “King of Kings” lost his seat on the analyst throne and no longer wears the stock picker’s crown. When asked what he learned from this disaster, he said, “You learn that even good management teams and macro- industry trends being favorable do not always translate into equity returns being positive.” Spoken by the fallen stock picking hero himself.

Here’s another example of a stock picking guru who fell from grace: On March 30, 2000, Tiger Management LLC confirmed that it was closing all six of its hedge funds. The legendary value investment manager, Julian Robertson Jr., stated that he could no longer understand this irrational market. For the first two months of the year, the funds were down 13%. Robertson wrote, “What I do know is that there is no point in subjecting our investors to risk in a market, which I frankly do not understand.” This quote comes from the head of 1999s second-largest hedge fund group in the world. If he and his numerous high priced analysts and strategists cannot comprehend how to beat the market, how can anyone?

In another tale of misfortune from the financial industry’s elite, the famous George Soros’ $14.2 billion investment firm lost two top managers when the world’s largest hedge fund lost approximately $5 billion during March and April of 2000. Here’s how the story unfolded: Stanley Druckenmiller and Nicholas Roditi were two of the top managers in charge of developing and implementing investment strategies for the firm. Druckenmiller managed the $8.2 billion Quantum Fund, which was down 22% for the first four months of 2000, while Roditi managed the $1.2 billion Quota Fund, which plunged 33% during the same period.

Although the Soros funds survived, albeit with new managers, how much of this poor performance can be blamed on the managers when no one can outperform a market over a long period of time? “I think there is going to be more fallout within the hedge fund industry,” stated a chief executive of Tass Investment Research. This is not the first case of a trader whose market calls have severely underperformed the markets. For many years, Victor Niederhoffer was one of Soros’ best traders. He later ran his own fund but was forced to close it in 1997 due to extremely heavy losses. History is littered with discarded, former legendary investors and strategists who eventually succumbed to the random and efficient markets, underperforming so dramatically that they were rarely heard from again.

Table 3-4

Michael Murphy has been hailed as the number one Technology Stock advisor. He offers his “Six Secrets to Successful Technology Investing.” However, his record is not so successful. For the five years ending March 1999 his Monterey Murphy Technology Fund had a mere 0.9% annualized return. An approximate index for technology stocks would be the NASDAQ 100 Index Fund, which had an annualized return of 41.3% over the same five-year period. The technology mutual fund average was only 25.5% and the S&P 500 over this period was 26.2%, (Table 3-4).

The financial industry has finally begun investigating the results of poor manager performances. In an article published in The Financial Analysts’ Journal in 1996, three top investment officers at Washington State Investment Board analyzed some of the information discovered by financial academia. One of the studies performed by Ronald Kahn and Andrew Rudd came to two main conclusions: (1) no persistence of returns can be found among U.S. equity managers, and (2) some persistence can be found among U.S. fixed-income managers, but not enough to justify the payment of active manager fees.

According to this and other information, the Washington State Investment Board, which had investment responsibilities in 1996 for more than $30 billion, restructured its investments. In 1993 it allocated approximately 70% of its U.S. equity portfolio to large-capitalization stocks, the bulk of which is invested passively in an S&P 500 Index fund. Their internal findings and newly developed and refined investment philosophy dictates that in the case of efficient markets, the best investment style is passive. Even quasi-active or enhanced strategies that take active bets in addition to a passive style will not add value. The board doubted that any value could be added to a passive investment strategy.

The Washington State Investment Board is one of the enlightened investment organizations whose principals realize there is no value to being an active manager. They know that active management lowers the overall value of the portfolio and that all efforts to increase the performance of the fund are futile. According to a study performed from 1987 to 1993, only one out of 28 major pension funds beat a portfolio consisting of a 60/40 split between the S&P 500 Index and the Lehman Bond Index.

Financial services firms make money through trading. They take a slice of the pie with every trade. With discount brokerages now in fierce competition, they have reduced their profit margins per trade. In order to maintain the same or greater profit, they must increase the number of trades individuals make. Trading frequently is a high cost activity, not only because of the trade commission paid to the broker, but also because of the spread between the bid and the ask, and the fact that most individuals buy stocks with low expected returns and sell stocks with high expected returns. Brokerage firms are similar to casinos, in that the longer and more often a person plays or trades in the market, the greater the chances that the brokerage firm will make money. The investor’s odds of losing unfortunately increase with the frequency of trading. In other words, trading can be hazardous to your wealth.

3.3.14 Stock Pickers Don't Want You to Know the Truth

For many mutual fund managers, analysts, traders, stockbrokers and various other individuals associated with the financial industry, the idea of index funds strikes fear in their hearts. This is because stock pickers and analysts charge very high fees on mutual funds, and these fees pay for a lot of the jobs in the industry. It is in the interest of these stock, time, manager, and style pickers to imply that a market can be beat by listening to their strategist or by risking money with their manager. Who will pay for their cars, houses and yachts? Thousands of jobs in the industry are redundant and completely useless to an investor. As one book from the 1940s asks, “Where are the Customers’ Yachts?”

If investors consciously want to gamble, then that is a different story. They can try to outperform the index and their fellow investors if they wish. But, they must realize they will not be able to outperform the indexes for any lengthy period of time. Although they may win a few times at the roulette wheel, they will count themselves lucky, but hardly skillful. After all, if a majority of the gamblers in Vegas actually won, who would pay for all the fancy lights.

Stock prices move randomly and reflect the daily fair market value of each stock. Therefore, the only hope of success for stock pickers is luck or chance. Time and money are too precious to waste on stock picking. The best investment strategy is to own a global, tax-managed, and diversified portfolio of index funds matched to risk capacity. If investments are not on the optimal returns line between risk capacity and risk exposure, then the appropriate market rate of return will not be achieved.

Simply put, stock picking is expensive speculation with negative expected returns relative to a blended benchmark. The best advice is to just let go of it, forget about it, stay away from it, and find something more productive to do.

3.6	Review Questions

Questions will appear at the end of each step to affirm your understanding of the information presented in each particular step. When you think you are sure of the correct answer for a question, click the "Answer" button to check.

1. The performance of stock pickers must be examined on an adjusted basis. When comparing a stock picker's portfolio to an index, which factors must be considered before determining if the stock picker has beat the index?

   a. proper accounting of returns, including cash flows in and out of the account
   b. the exposure to market risk, size risk, and value risk of both portfolios
   c. level of diversification of the two portfolios
   d. standard deviations or volatility measurements
   e. all of the above

2. One of the problems of stock pickers is:

a. They focus on well diversified portfolios.
b. They are focused on the short-term rather than long-term results.
c. They adhere too closely to one style or benchmark.
d. They don't take enough risk.

3. Stock pickers pay more taxes than indexers, because:

a) their annual returns are higher.
b) the average actively managed portfolio has a 45% turnover rate, while index funds range from 5% - 35%.
c) the average actively managed portfolio has a nearly 100% turnover rate, while index funds range from 5% - 35%.
d) they don't pay fees or commissions to their brokers, thereby offsetting the higher taxes.