Why We Prefer Investing to Speculating
They were the "Mickey Mantles" of the investing world.
That's what they were called in Businessweek magazine. From 1990 to 2004, starting with a base of $5 billion, they earned more than $12 billion in profits. After accounting for new capital into the fund, they earned an average annual return of 16%.
No, these guys weren't hedge-fund managers. They didn't live in New York. And they certainly didn't invest like most professionals. That is, they didn't copy the standard indexes, with minor exceptions.
Instead, they invested in a new way. It was a style that focused on absolute value across all asset types. It was an approach that matched the long-lived nature of their institution. As a result of this approach and their talents, they crushed the standard professional benchmarks: 18% annualized return on domestic bonds versus 8% industry benchmark… 23% annualized return on foreign bonds versus 7% industry benchmark… 16% total annualized return versus 10% for the average institutional fund.
The leader of this group of investing all-stars was Jack Meyer.
As I mentioned, Meyer wasn't a hedge-fund manager – at least, not in the traditional sense. He wasn't a mutual-fund manager, either. Nor did he work for a pension fund or an insurance company. Instead, he held one of the most prestigious investment jobs in the world: He managed the Harvard University endowment.
Jack Meyer didn't merely make Harvard a lot of money during a massive bull market in stocks. He made Harvard excellent returns, while running a portfolio that had little negative volatility and wasn't correlated to the stock market. In short, Meyer and his team were accomplishing what most academic economists would argue is "impossible." They were earning vastly higher rates of return without taking any additional risk. In truth, the portfolio was much safer than the stock market.
Meyer could have run a private hedge fund and earned hundreds of millions of dollars. But instead, he simply requested that his team be paid bonuses when they beat their benchmarks. That is, they wanted a small piece of the excess returns their work generated. To make sure the profits were really earned, when they did get a large bonus, a big reserve was kept and the award was subject to a "clawback" if there was underperformance from the benchmark in the future.
In short, to get paid any significant compensation, Meyer and his team had to vastly outperform the markets. And they did…
Meyer and his team sometimes (not every year) raked in annual compensation of more than $20 million. This seemed outrageous to some of Harvard's famously liberal professors and the university's class of 1969, which wrote a letter condemning Meyer's compensation. Yes, the "Summer of Love" students were apparently offended by the capitalist idea that it's worth paying a few million dollars to earn billions.
Meyer and his team were delivering the best possible investment results – better than just about any other investment manager in the world. And they were paid less than half what it would have cost Harvard to have its endowment fund managed by an outside firm, whose performance would have been far worse.
In short, Meyer and his team were the greatest bargain in finance… and the liberal dunderheads at Harvard were too smart to understand the bargain they were getting.
Remember, the liberal academics at Harvard had all been taught that the performance Meyer's team had achieved was only luck. The "efficient market hypothesis," which is the central tenet of modern, market-based economics, claims that only random chance could explain such an outstanding performance.
(For more about the conflict between academic theory and real-world successful investing, please read the "Superinvestors of Graham and Doddsville" speech given by Warren Buffett on May 17, 1984, to celebrate the 50th anniversary of Graham's opus, Security Analysis. You can find a copy of the speech here.)
So how did Meyer earn 16% annually, with almost no volatility?
The secret to his success was investing in private equity, hedge funds, and illiquid asset classes that Wall Street's big banks largely ignored – like timberland. (Wall Street's banks specialize in "liquid" securities whose prices constantly change and whose shares are constantly changing hands. High-quality timberland might only change hands once every generation.) Meyer only put around 25% of the fund in "regular" stocks and bonds.
Just think about what a contrast that is to most people's portfolios, where virtually all assets go into the stock market.
Meyer was especially focused on timber because of its outstanding long-term performance and its lack of negative volatility. (Timberland rarely, if ever, declines in price.) From 1997-2005, Meyer amassed 2,000 square miles of productive timberland. That's 50% larger than the entire state of Rhode Island.
These assets generated large amounts of cash flow annually. Plus, the price of timberland continued to go up too, nearly every year. By 2004, 10% of Harvard's portfolio was invested in income-producing timberland. Meyer even employed in-house lumberjacks to assess potential forests.
Despite the success, the eggheads at Harvard never bought into the idea. They were too smart to believe the markets could be beaten.
Even though Meyer said his job managing Harvard's endowment was "enormous fun"… and even though he believed "this is the best job in the investment business. There's no other job where you can try to aggressively add value across all the asset classes"… he resigned in January 2005. His team left with him. What happened?
The short answer is: Larry Summers.
Summers is the iconic, modern, academic economist. He's the nephew of Paul Samuelson, the M.I.T. economist whose textbook, Economics, has been taught to nearly every American college student since the early 1960s. To give you a flavor of the politics of the Samuelson text, its early versions predicted the Soviet Union would overtake the U.S. as the world's leading economy. Until the mid-1980s, Samuelson continued to laud the economies of Eastern Europe. (More recent versions have dropped the Communist hero worship.)
At age 16, Summers was accepted at M.I.T., where he planned to study physics. If only he had…
Instead, Summers graduated with a degree in economics. He then went to Harvard for graduate school, where, at age 28, he became the youngest tenured professor in the university's long history. His academic pedigree and performance were unmatched. He would become Harvard's president in 2001.
Prior to returning to Harvard as president, Summers served as deputy secretary of the Treasury and then Treasury secretary under President Clinton. He was the protégé of former Treasury secretary Robert Rubin. This is where the trouble started…
You might recall that in August 1998, the Russians defaulted on their sovereign debt. This started a chain reaction in the world's bond markets, which had already been wounded by several Asian sovereign defaults in 1997. The biggest casualty of the markets was a very large and high-profile hedge fund called Long-Term Capital Management.
Long-Term Capital Management was the crowning achievement of academic economists. The firm was founded in 1994 by John Meriwether, a Salomon Brothers trader who became enamored with the theories of two famous, Nobel Prize-winning economists, Myron Scholes and Robert Merton. They won the Nobel Prize in 1997 for a formula that used the efficient-market hypothesis to compute optimal derivatives prices. Meriwether figured out that by using a similar formula, he could trade sovereign bonds – like Russia's sovereign bonds – and earn what looked like risk-free profits.
These guys became so convinced in the theory, they began trading using up to 100-to-1 leverage. Of course, nothing in their models anticipated how irrational other investors would behave in the event of a Russian default. The wonks at Long-Term Capital used to show potential investors that only the most severe market disruptions – so-called "seven sigma" events – would cause them to lose money. They claimed that such events could only happen once in 1,000 years. But actually, such an event occurred within four years of the creation of Long-Term Capital. It was truly an epic financial disaster. The firm lost almost $4 billion in just four months, beginning in August 1998.
I was covering emerging markets at the time for a small economic research firm called Welt Research. I recall talking to a bond trader at a conference who told me he'd gotten a call from Long-Term Capital about selling some of its Russian bonds. He said in the current market, potential buyers were bidding around $40 and sellers were asking about $45. That was an extremely large and unusual "bid/ask" spread, and it reflected panic in the market. He said the Long-Term guy kept shouting at him that his model said the bonds were worth at least $84. And while he was shouting, the market slipped to $35/$40. The trader simply replied, "I have the market now at $35/$40… Are you a buyer or a seller?" The Long-Term guy hung up.
The moral of the story is that markets don't always behave in ways that are rational. For long-term investors who hold unleveraged positions in assets like pine forests, these kinds of events are completely meaningless. But for academic economists who believe their models are reality, it frequently leads to disaster.
That's certainly the case with Summers. In the documentary about the 2008 financial crisis, Inside Job, filmmaker Charles Ferguson says of Summers, "Rarely has one individual embodied so much of what is wrong with economics, with academe, and indeed with the American economy."
It was Summers, who, along with Rubin, dismissed repeated calls for the regulation of derivatives in 1998. It was Summers, who as Treasury Secretary, lobbied for the repeal of the Glass-Steagall Act, a law that permitted the formation of the financial-services monstrosity Citigroup. Yes, that's the same business his mentor, Rubin, had found a kind of employment with… as a vice-chairman, who earned more than $100 million over several years without having any particular duties.
After leaving government in 2001, Summers would amass a fortune (around $20 million) via consulting and speaking fees paid from the financial-services industry.
Just remember… it was the commercial banking sector's deep involvement in derivatives that led to the worst aspects of the financial crisis of 2008/2009. Summers helped create these markets… and he earned millions of dollars doing so. Meanwhile, taxpayers were left holding trillions in losses, when once again, the economic models didn't match reality.
But… nowhere was the curse of Summers more plain to see than at Harvard.
When Summers became president of Harvard, he immediately butted heads with Meyer. Professional investors and academic economists often clash. Academics know all about how the markets ought to work. But those theories assume everyone in the market is rational. One of the first things you learn as a professional investor is that markets are never rational in times of stress, which tend to be the only times that matter.
According to the Boston Globe, at least once a year, Summers and Meyer bickered about Harvard's "cash operating fund." This was the pile of money that was held in reserve for operational expenses and emergencies. You could think of this pile of cash as Harvard's reserves.
Summers insisted on investing large sums of Harvard's cash operating fund in Jack Meyer's long-term holdings. That's tantamount to investing your rent money in antique cars and paintings by Renoir. Those markets are very illiquid. While the values might be there, getting your money out in a pinch will prove very difficult.
Meyer and others repeatedly warned that the long-term nature of the endowment's investments were an inappropriate place for operating funds. Meyer had discovered that the greatest opportunities in the market lay in very illiquid assets. These investment vehicles did not trade frequently, and so their prices were not well-gauged by other market participants. Since Harvard didn't need to cash in any significant portion of the endowment in any given year, Meyer could safely invest for the long term, where other investors could not. After all, Harvard's operating timeline is forever.
Summers simply didn't believe a day would come where the liquidity of Harvard's holdings would matter. He was completely wrong – in the way academic economists are always wrong. And Jack Meyer knew it.
Besides the disagreement over strategy, the two also clashed because Jack Meyer made $30 million in 2003. The payment was, of course, earned by the investment performance of his team. All of it was part of his existing contract, a contract that was very cheap compared with what Jack could have readily made on Wall Street. Nevertheless, Businessweek noted that by 2005, Meyer had "grown awfully tired of the annual debate over how much he and his top managers are paid."
So Meyer resigned. But his successor wasn't in place until 2006. Throughout this transition period, Summers inserted himself into several of Harvard's financial decisions, including:
- Selling nearly 1 million acres of cash-producing, inflation-hedging, capital-appreciating timber and mineral rights.
- Continuing to plow cash from Harvard's cash operating fund into the endowment fund.
- Announcing an ambitious expansion project in Allston, Massachusetts, which Harvard would partially finance with a series of complex interest-rate swaps.
It is the third item that has drawn the most attention… the infamous "Summers swaps."
These swaps locked Harvard into 2004 interest rates for construction that was planned to start at some point in the future. Summers had said publicly that he believed interest rates would be rising in the years to come. These swaps were a huge bet Summers made on rising interest rates.
But interest rates didn't rise. Instead, by June 2005, the value of the Summers swaps had dropped to negative $500 million. (This is the amount Harvard would have to pay to unwind the contracts.) At this point, Summers could have unwound some positions or hedged Harvard's exposure with additional contracts. But he stayed put.
Ultimately, Summers would not be around to deal with the fallout of his financial creation. In 2005, he presented at a Conference on Diversifying the Science & Engineering Workforce. In his speech, Summers suggested that one reason for a lack of women in certain science and engineering fields is that they lack the "high-end aptitude" of their male counterparts. (Seriously… we can't make this stuff up.) A "no confidence" vote from Harvard's faculty followed. By 2006, Harvard had fired him.
In 2008, the financial meltdown hit Harvard hard. The endowment ultimately lost 27% of its value in the aftermath of the crisis, in part because Summers had replaced rock-steady timber investments with volatile financial assets. And when Harvard's endowment plummeted, the school's cash operating fund dropped nearly $2 billion… thanks to Summers' decision to commingle the two funds and the huge bet he made on interest rates. Interest rates continued to fall. And finally, Harvard had to pay $1 billion to unwind the contracts.
- It's nearly impossible to tabulate the collateral damage from the Summers era at Harvard. But we'll try:
- $1 billion to unwind the interest-rate swaps.
- $2.5 billion borrowed to pay bills, salaries, and generally fill the gap left by a depleted cash operating fund.
- Untold millions (perhaps billions?) in lost income from timber that was sold. (The endowment fund lost 27% of its value in 2009, when many of these losses were recognized.) We estimate this land would have generated up to $150 million per year, tax-free.
- Development of the new Allston campus had to be temporarily scrapped.
The whole ordeal was called "a case study of what not to do" in a Bloomberg article.
You may be glad to know that as of 2013, Harvard's endowment is back up around $32 billion, or $5 billion shy of its peak. That's because it has again embraced the practices of Jack Meyer.
Meanwhile, Meyer walked across town and set up a hedge fund, Convexity Capital, at the top of the John Hancock building. In 2009, the same year Harvard's endowment recorded a 27% decline… Convexity's funds beat their indexes by an average of 20 percentage points!
Convexity now manages more than $14 billion, including a lot of money from Harvard. Yes, that's right. Harvard invested $500 million in Convexity. Assuming a 25% profit on its $500 million investment in 2009, Harvard would have paid Meyer at least $100 million in fees for that year alone – far more than it cost to have his entire team working exclusively for the school.
And… what has happened to Summers?
He's served on a handful of company boards. He's been on the United Nations' Panel of Eminent Persons. He was even Obama's key economic decision-maker as a director of the White House National Economic Council. In December 2012, Summers was in the news when his article "How to Target Untaxed Wealth" was widely circulated. Years after butting heads with Meyer, Summers is still hung up on those who make "too much money."
Despite the high-powered players and the complex-sounding strategies, the story of Meyer and Summers really boils down to the classic trade-off between investing and speculating.
Speculators care deeply about volatility and price movements because they are (almost always) leveraged. They've borrowed money to make a trade. They face an interest-rate charge to carry the position. And if the price moves lower, they can lose a fortune – even if the underlying actual value never changes.
Speculators believe they can forecast price changes… and the good ones can.
For example, market participants are often forced to make illogical trades to conform to government regulations or internal trading rules. One famous example occurred in 2005 when General Motors and Ford lost their investment-grade credit ratings. That forced almost all publicly traded bond funds to sell these bonds. The funds' internal rules demanded they hold only investment-grade credits. The two automakers were the largest private issuers of debt in the United States. When their bonds sold off, it created a massive dislocation in the market. It wasn't hard for speculators to imagine that this massive forced wave of selling of the most widely held issues would cause the prices of these bonds to fall. And they were right.
Of course, the actual value of those bonds (while declining through time) didn't change massively overnight. Only the price changed.
Investors, as opposed to speculators, specialize in values.
Investors look for situations where the price of an asset has become disconnected to its actual value. The cause of this disconnect doesn't matter. It could be because a particular company or industry is out of favor. It could simply be because, as with timber, not many investors understand the asset or are interested in it.
Investors who are experts in value end up caring little about price… unless the price is too cheap, in which case there's an opportunity. Richard Russell, who's been writing newsletters for more than 50 years, put it best in his famous essay "Rich Man, Poor Man"…
The wealthy investor tends to be an expert on values. When bonds are cheap and bond yields are irresistibly high, he buys bonds. When stocks are on the bargain table and stock yields are attractive, he buys stocks. When real estate is a great value, he buys real estate. When great art or fine jewelry or gold is on the "give away" table, he buys art or diamonds or gold. In other words, the wealthy investor puts his money where the great values are…
If you think about it, that short quote exactly sums up Meyer's approach to wealth-building for Harvard. It's an example we'd urge you to follow. Never think about what you ought to be investing in – stocks, bonds, or real estate. Instead, just look for great values. When you find them, you'll have a lot of "staying power" and the ups and downs of the stock market won't mean so much to you.
You probably think about your own home this way. If you've lived in it for a while, you know a lot about its value. And if it's a valuable property in a stable, desirable neighborhood, then the volatility of home prices over the last few years probably hasn't bothered you at all.
Contrast that feeling to your experience in the stock market in 2008 and 2009. You were likely terrified as prices collapsed… in part, because you can't know as much about the value of your stocks as you can the value of your home.
At Stansberry Research… we prefer to be investors more than speculators. That is, we prefer recommending businesses we know a lot about, whose value we can accurately and confidently ascertain. We seek to become experts on assets we believe are safe, cheap, and likely to produce substantial amounts of income.
Our view is that your goal as an investor is always based on your portfolio's total return. It doesn't matter (very much) if you make 500% on a speculation because you're only going to put a small amount of capital in a risky situation. That's why we greatly prefer situations like Hershey (NYSE: HSY), which offer us tremendous value, reasonable income, and great safety. These ideas are the kind that you can use to build a life-long portfolio, ideas that will actually create wealth for you and your family in a reliable way.
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