Wednesday, August 22, 2012

John Bogle: The Clash of the Cultures

John Bogle has written a new book with the title:

The Clash of the Cultures: Investment vs. Speculation

The book is his 11th and seems, at least in part, an expansion of this essay written by Bogle:

The Clash of the Cultures

The essay is well worth reading with lots of useful insights. I suspect that's the case for the book as well.

In the essay, Bogle argues that today's model of capitalism has lost the optimal balance between the two very different cultures of speculation and investment. It is, in his view, to the detriment of society. From the essay:

"As a member of the financial community, I'm concerned about these changes. I'm also concerned as a member of the community of investors, and as a citizen of this nation. The issue that concerns me is, simply put, today's ascendance of speculation over investment in our financial markets; or, if you will, the ascen­dance of the culture of science -- of instant measurement and quantification -- over the culture of the humanities of steady reason and rationality."

To me, it's partly an emerging preoccupation with measurement over meaning.

In no particular order, here's my take on some of John Bogle's notable lessons and insights (among many):

- In the book he points out that there are more than $ 30 trillion worth of trades each year, yet fresh investment of capital into things like businesses, new technology, medical breakthroughs, plant and equipment is less than 1/100th that amount (~ $ 250 billion). So our system now has more than 99 percent speculation for less than every 1 percent of actual capital formation. Keep in mind that this whirlwind of speculation is not limited to stocks. There's been an explosion of derivatives trading (to say the least) as well. We'd benefit from more focus on intelligent capital formation and less energy spent on the zero-sum (or worse) activities. It certainly would seem to be better use of our brightest minds (His essay compares slightly different numbers: Bogle says that annual stock trading volume is $ 30 trillion while average annual new issues of common stock is $ 145 billion. So trading represents more than 200x the amount of equity capital that's provided to businesses.)

- There's a big difference between "value-creating" activities and "rent-seeking" activities. One adds value to society while the other subtracts value. Trading by definition subtracts from investor returns as a whole and the costs of all this trading creates a real economic drag. Some of those costs are easy to measure, some are not, but all are very real. This is really no different than what Warren Buffett separately referred to as Newton's 4th Law and The Invisible Foot. It's the "croupier's" take. As an investor, minimize those costs and you can end up way ahead in the long run. As Bogle points out:

"In investing, you get what you don't pay for."

- He also is leery of investors being charged excessive amounts for slickly marketed but overly complex advice or investing strategies. Buffett made a similar point:

"...most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising 'Take two aspirins'." -Warren Buffett in the 1987 Berkshire Hathaway Shareholder Letter

- Bogle considers the proximate cause of our current predicament to be what he calls the "Double-Agency Society" that has evolved over the past several decades.* Essentially we now have large corporate manager/agents interacting with large investment manager/agents who focus excessively on near-term stock price fluctuation over long-term intrinsic value creation. Of course, there are very good corporate managers and investment managers. Yet, too much money is now engaged in speculation with little interest or concern for long term effects. If too many of those agents are primarily focused on the near-term price action and outcomes, who picks up the slack when it comes to building entities with enduring value? Who is really looking out for long-term shareholder interests?

More from Mr. Bogle's essay:

"If market participants demand short-term results and predictable earnings (even in an unpredictable world), corporations respond accordingly."

If you're likely selling the stock soon long-term outcomes aren't going to be front and center. Fixing poor corporate governance isn't going to be of primary importance. Nor is making sure the long-term interests of owners are served over the interests of management. In other words, the persistent effective application of capital (financial and intellectual) with some scale and a focus on long-term effects matters to civilization. We end up with much unrealized potential when so many participants are focused on what are really just narrow short-term oriented games.

As at least part of the solution, Bogle argues strongly in favor of a "fiduciary society" -- where manager/agents are required by federal statute to place the interests of owners first -- to replace the current "agency society".

I'm sure more than that needs to be done but it seems a pretty good place to start.

Bogle: A Crisis of Ethic Proportions

*****
My focus in investing happens to be on individual equities while Mr. Bogle's certainly is not.

In fact, he's very clear on this point. He thinks most investors should not be buying individual equities.

Despite this key difference, his wise advice (and conscience) has always been very useful to me and I suspect may be to just about any long-term investor.

In Mr. Bogle's view, investors should capture the growth in intrinsic value of corporations in a broad index using a vehicle that minimizes frictional costs. It's very hard to argue with that approach since the evidence is strong that too few investors actually do better than a broad equity index.**

Still, I don't follow his specific advice since I'm a buyer of individual stocks. I also prefer a more concentrated portfolio. Yet I own individual stocks with a similar set of principles and objectives in mind.

My results are similarly derived from the growth in intrinsic value of the businesses themselves over a very long time frame (that and consistently buying shares at a clear discount to my estimate of intrinsic value), not some special aptitude on my behalf to jump in and out of their shares at precisely the right time. My emphasis is always on long run compounding effects -- the growth in per share intrinsic value of good businesses -- while minimizing frictional costs.

I simply attempt to capture the long-term intrinsic value growth of a more limited number of businesses compared to a more broad-based index. The downside, of course, is if my judgment of individual companies and their long run prospects is not consistently sound.***

If I wasn't comfortable with buying individual stocks I'd certainly also use index funds. Either way, I'd never trade. It's a simple matter of knowing where one's limits lie and staying well within those limits.

Some final thoughts. I'm never trying to outguess or "play" market price action. It's my view that too many are involved in that sort of thing. The market is there to serve. If a stock I want more shares of gets cheap, I buy it with the intent to own for a very long time. Occasionally, the market in general or a specific stock goes to the other extreme and requires some action, but I rarely sell shares I like just because they've become a bit expensive. My reason for selling will usually be more along these lines:

The opportunity costs are high. In other words, capital from one long-term investment is needed to fund another long-term investment that has plainly superior prospects.

I think that buying/selling should be kept to a minimum and it's not just because of the associated frictional costs. It is because each move is just a chance to make a mistake, but the illusion of control sometimes masks this reality. So, at least to me, it's best to reduce the number of moves to those where the confidence level is very high.

Otherwise, the price action of markets and of individual securities is of little interest.

Adam

* In 1950, individual investors held 92 percent of equities while institutional investors held 8 percent. These days 70 percent is held by institutional investors.
** I realize it has been a tough decade for many equity indexes. The intrinsic value of corporations had to catch up to the extreme late 90s market valuation. That doesn't make Bogle's approach any less wise. It just means expectations need adjustment. Unfortunately, I doubt the next decade is going to be particularly wonderful for most indexes. It's a very real dilemma for investors.
*** It's a level of diversification consistent with Warren Buffett's and Charlie Munger's thinking:
"We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter

"I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken." - Charlie Munger in this 1998 speech to the Foundation Financial Officers Group

Yet the right level of concentration depends on the individual investor and their specific circumstances. There's naturally just no one right generalized answer.

Press Release - The Clash of the Cultures
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