I considered it remarkable that these men attended the lunch in the first place; even more so to hear them take without rebuttal a line which should have been contentious. Certainly this type of lunch would never have taken place five years ago. Even if it were arranged just two years ago, it would have been poorly attended or several people would have walked out.

This lunch illustrates to me the acceptability of the academic in the investment world today. This acceptability is excessive and requires as much examination as the nonacceptance of the academic view ten years ago. Nearly every major institution has an academic or two on its consulting staff. Some of them are there for economic consulting. Others attend as management consultants to advise about the way the business should be run. Very few utilize this opportunity to be kept abreast of the large amount of securities research that is being done by academic institutions. Certainly no one to my knowledge in the institutional community is directing academic research along lines that are designed to find profitable investments or market imperfections.

The academic has a great influence on the investment business through his students. Many of those who join the professional staffs of large institutions have had business-school training at one of the graduate business schools in the country. There they are exposed to the leading teachers of investment management who espouse the primacy-of-marketing view. These young men have been coming into institutions for the last several years accepting the notion that professional service is difficult if not impossible.

The academic is the one who set this notion underway. Perhaps it was fueled at first by cynicism of the academic to the overpaid investment manager. Now the cynicism has a momentum of its own, aided by poor markets. The academic is in a leadership position and is well respected within the practicing institutional community. Few academics have been called upon to engage in long-range industrial planning, although it is a role for which they seem ideally suited.

Most academics I have known have had a hard time investing for their own account. There was an investment club of Harvard Business School professors in the 1960’s which drew on the knowledge of about twenty senior faculty members. All of the input from consulting, case studies, and intelligence of the group was available for decision- making. The only investment that made any profit involved early purchase of stock in the Boston team of the American Football League. The students followed it to see if weekend game scores had any relationship to stock price.

My firm has made itself available for case studies and has maintained a close contact with academics. I find increasing disagreement with the implications of some of the views they hold. However, I have few disagreements with the sources of their observations. The academic community has been the principal leader in the use of quantitative techniques for investment decision-making.

As we have moved from qualitative judgments about securities and markets and acquired access to inexpensive but massive computer power, quantitative techniques for securities selection—essentially screening—have become practical. Few institutions realize that through the use of quantitative techniques they can run portfolios containing many more securities than were possible before.

There is no longer need to rely upon the few issues in a portfolio that one can follow by conventional techniques. The establishment of mechanical strategies, with automatic quantitative rules for purchases and sales, was spawned within the academic community through the research they did in the late sixties. By the late seventies, this research should be quite commonly employed for large institutional portfolios, with hundreds of securities followed by machine, where the portfolio manager generally establishes the criteria for selection or elimination, while the machine does the rest.

This major step will make a portfolio manager much more productive and will eliminate a great deal of the work and duplicate effort presently being done. It is the academic who is introducing quantitative discipline into investment operations.

Government

The government’s role in the investment environment is ambivalent. Government seems to be dedicated to protecting the small investor at the sacrifice of the large investor and has not yet decided whether institutions are really a collection of small investors or a single large investor. Studies such as the Security and Exchange Commission’s institutional study of the early seventies confuse more than they illuminate. The SEC’s conclusion that institutions did not dominate the market 15 laughable on the surface. Anyone who has testified before the SEC in Washington comes away feeling convinced that the investor process is not understood. Well-meaning but inexperienced young lawyers are operating in an excessively complex and subtle field. Investment professionals can usually beat these people in any type of competition they may wish to undertake.

I have been at the SEC on several occasions and come away feeling sympathetic. Most of the work is done by young lawyers who are putting in a couple of years of internship before they go off to more lucrative work with law firms specializing in investment matters.

I was once called to testify in connection with possible institutional interference in the proposed merger of Brunswick and Union Tank Car. Brunswick was a quite leveraged growth company headquartered in Chicago. Union Tank Car had a complementary financial structure whose management might have been the ultimate successor to the combined companies. Because Union Tank Car had a history of sharply lower rates-of-earnings growth, several investors in Brunswick were unenthusiastic about the merger prospects. The Investment Companies Act requires that mutual funds not participate in management decisions before being asked to vote on a corporate matter. The specific issue being investigated was whether or not Keystone had illegally influenced Brunswick against the merger by soliciting the opinions of other share holders of Brunswick.

This was a very difficult case to pin down. In conversations with the company and, indeed, over dinner one night with the Brunswick president, I expressed my views that the proposed merger was not in the best interests of shareholders. Keystone would vote against the merger. The issue was whether we had discussed our vote with other shareholders. The Boston investment community is quite small and it is not uncommon for institutions who own the same stock to exchange views and opinions or information about the company. Surely some such conversations took place on the Brunswick-Union matter, but there was no specific campaign to drum up support against the merger or specific calls for that purpose.

I spent a morning being questioned by an intelligent, intense young lawyer who had telephone logs of the company officials—an accurate description of what I had said to the company. He was looking for evidence of specific conversations with other institutions in which I might have tried to influence their decision for or against the merger. Though I could not think then, or now, of any specific conversations, it was reasonable for some to have occurred. Indeed, they would have been commonplace.

There have been proposals that government legislate the capital allocation process. Institutional investors tend to favor the large and historically successful companies and leave the smaller, harder-to-follow ones alone. The cost of equity capital for smaller companies is much higher as a result, and serious consideration is being given to the idea that large investors, primarily banks, might be required to invest a portion of their funds in a selection of smaller company stocks. If such a law came about, it would be a subtle form of capital tax and would defeat the notion that capital is attracted to investments where it can get the highest return commensurate with risk.

Government is clearly going to have a much bigger role in the investment process than was formerly the case. Tax-exempt funds, like pension plans and foundations, must apply annually for tax-exempt status. Someday, a legislator is going to decide that those funds can be allocated by government fiat without passing new tax laws. The securities industry has a tradition of self-regulation which has been proven faulty. Government will assume these burdens.

Proposals have been made for a Federal Securities Exchange like the Federal Reserve System, but for stocks and bonds rather than check clearance. Such proposals have great merit and indicate, since they must come from government, how backward is self-initiated change in this field. In a sense, there is little reason to differentiate between bank deposits and equities. They are different forms of capital but can logically be treated within the same system.

Brokers

The typical individual investor expects too much from his broker, and the broker lives out this fantasy by recommending stock that, he claims, will produce great profit instantly. In fact, in the new-issue crazes which come near the end of every bull market, the broker is the conduit through which the individual investor gets instant profit. It is the case unfortunately that the investor usually ends up with losses on the new issues after the bull market tops out.

Institutions, on the other hand, expect too little from brokers. They are not demanding enough for the huge commission flow for which they are responsible. In the year in which Keystone’s brokerage commissions totaled slightly over $20 million, half went for investment services. These are the so-called soft dollars which are used to designate money owned by and spent for the ultimate client. Brokerage firms often act as conversion agents of soft dollars (commissions) into hard dollars (money spent to hire consultants to do research and the like). The conversion rate between soft dollars and hard dollars used to be as high as five to one, but in the tight markets of 1974 it was running at approximately two to one.

Because the demands were too little in the post-May 1, 1975 negotiated rate environment, institutions were ruthless in driving charges down 50 percent and in seeking a price appropriate to the value for services rendered. Had demands for better services been made earlier, and they would have been if the institutions had been spending their own money on commissions, the cuts would have been tempered.

The principal motivation of a broker is sales. His task is to sense what his clients want to buy or sell and provide them with valid reasons for doing so. When I took over the operation of a large fund, I noticed that most brokers would tell me how brilliant I was to own the stocks I already held in the portfolio. They promised their organizations would follow these very closely for me. I found few suggestions or new ideas and almost none that could be classed as controversial.

Indeed, I was attracted to these brokers; they had the same investment style I was pursuing. I rewarded them with large commissions which invariably brought them back to tell me again how good the portfolio was. This helped the broker’s pocketbook but it added little I might learn about the portfolio nor brought out other things I should be pursuing.

Brokers are aggressive salesmen but very conservative investors. They have learned that it is safest to operate with the consensus, to be noncontroversial, and not to expect too much in the way of sharply above-average or sharply below-average results. When brokers are placed on a board of directors, they become the most cautious members and shun high business risks. Even the brokerage business itself, beset by problems as it is, has suffered because of its inability to change. Brokers are far better at raising capital for older ventures than for newer ones. Very few, for example, have become leaders in venture capital. Instead, the insurance companies—by reputation even more conservative investors than brokers—have held the leadership position.

The principal service one can expect from brokers is gossip. Certainly this is not widely advertised, nor is it even understood by investors. The brokering and sales functions come in contact with many investors during the day to the extent that the broker is attracted to those with the most commission dollars; consequently, those who are currently most active in the market. His contact is weighted toward people who are most responsible for affecting current market prices.

If a broker is an accurate observer (and most are), he can be expected to provide an instant polling of investor attitudes; gossip on changes in favoritism, personnel, different industries, or companies; and even information on which investment strategies are working. Most brokers would put the traditional small-town telephone operator to shame as sources of community information. Much of the evidence that the market is efficiently priced is attributable to the successful gossip function of brokers. They are constantly evening out pricing imperfections. Brokers can be expected to enjoy displaying how well connected they are with the largest customers, and a little bit of flattery will extract all of the information one might want. Most brokers do not realize how important this gossip function can be to an investor; they do not even think that it is very highly prized. It usually can be extracted as part of the social interaction between a broker and an investor, rather than as a specific service being provided for commission dollars.

Brokers are caught in the dilemma of having a service which is priced higher than the level necessary to support a specific security execution. By tradition, the execution service is relatively undifferentiated and can be effected by any one of hundreds of brokers. In order to attract customers, brokers have added analytical, economic, and even culinary services for their principal accounts in order to attract the business which will contribute so importantly to their overhead.

There are probably few industries where so much general information is available as the investment business. Brokerage reports and masses of statistical data are provided free or at very low cost, but few know how to use this resource. In fact, few people in the investment business as a whole have the faintest idea what sort of information works and what does not work.

One of the principal activities of a brokerage research department is to forecast earnings per share for companies which they, like other research departments, follow. The technique most widely employed by an analyst is to call the company in question. A fishing conversation will occur with the company executive being asked to accept an estimated figure. The analyst will then fill in some assumptions on a pro forma income statement to show how this result comes about and present it as original work. There is ample evidence that earnings per share forecasts are not very good and even when accurate they have already been discounted in the marketplace. They are not very profitable exercises, although hundreds of millions of dollars are spent by brokers in this activity.

Perhaps a broker performs a ceremonial function for investors. Frequently a customer asks his broker if it was all right to buy some particular stock. The broker replies, "Yes, I have checked with our research department and they say it is." A ceremonial exchange is taking place to give the customer confidence that a decision involving large sums with a high uncertainty of success is likely to be correct. One goes to the high priest who offers a few mumbo-jumbo words to the investment gods. The priests extract a high tax for this service. And the investor leaves the broker’s office assured that his investment progress will be bountiful because the proper oracles were consulted.

Brokers provide good training to investors; whether institutional or individual. Several days spent in the brokerage operation gives one an insight into the activities of other investors. The contrast between the pace in the trading room with much frantic activity and the calm reflection of the corporate finance department suggests totally different business attitudes. Brokers have little desire to plan in their own business. Not only are they traditionally capital short be cause they distribute profits each year, but the business is usually tied to the activities of the few individuals rather than to a continuing corporate entity.

Two weeks after I was first employed by F. S. Moseley & Co., I submitted a planning report and the observations I had made about brokerage houses during the interview process at the Harvard Business School. I felt that these observations would be useful insights in the determination of overall firm policy, and perhaps I also hoped that it would win a place for me in the high planning councils of the firm I had joined.

The seventy-year-old managing partner, John 0. Stubbs, took one look at the outline which I had carefully prepared and handed it back with a look which put me in my whippersnapper place and said, "The only thing you have to remember here is to sell stock to anyone who has money. The only reason I wanted a research department is because our largest customer says it’s a good thing to have. Our largest customer wants to do business with us anyway and needs an excuse. I don’t think you fellows can pick stocks any more than anyone else and certainly I don’t need you. But if every other major firm is going to have a research department, I guess we have to and it had better be a damn good one."

I was set back on my heels, yet I learned a clear expression of the essence of the brokerage firm behind its genteel facade. I learned early that it really moves on sales and I structured the research department to sell directly to institutions. I also developed a reasonably large personal brokerage clientele myself. Any administrator in the brokerage field who does not control any commission business is the first to be chopped in a cutback.

A broker is always dealing with divided loyalties and conflicts of interest. He can always be expected to select the alternative which offers him the highest and most stable return. An obvious conflict is between corporate finance clients and brokerage clients. When a brokerage firm has an underwriting, it prices the issue at a price that will sell. Part of the selling process, however, is the reputation of the investment firm and its ability to continue to follow a security and to provide information (or at least ceremonial services) which make investors think the company is still a good one. Further, it creates the impression that any problems are only temporary, and these will be overcome by the extraordinary skill of management.

A glaring example of this conflict occurred when I was asked to visit one of F. S. Moseley’s corporate finance clients—Sprague Electric—at a time when the stock was down, and the company was particularly insistent about getting some support for its falling stock price. The company was nearby and was in a field I knew quite well. I welcomed the opportunity to spend a day meeting with the top people.

Everything I learned from the company visit suggested that the electronics business was in a very bad way; Sprague worse than most. Its business, passive components, was being made obsolete by integrated circuits, in which it was not a leader. Selling prices were coming down and costs were going up. There was little good about the situation, except that Sprague was an old and stable New England company that probably would weather this temporary condition as it had many others. The company was very honest about its difficulties and a number of the management people I met were quite candid in explaining the problems. After all, I represented the underwriter and was considered one of the family.

I returned to the office and wrote a sale recommendation on the company. I sent the draft directly to Sprague’s chairman for his comment and review before it was to be sent out to customers. When the managing partner came in the next day, I heard some thundering about writing a sale recommendation rather than a buy recommendation on the firm’s pet company. He roared that I must have misunderstood the purpose of my visit and, thank heavens, that my report didn’t get out to the public. There was no question that I had violated one of the principal rules of the firm: you never dislike one of your own underwritings. Clearly this report never saw the light of day and our clients went uninformed about the business problems at Sprague.

Instead, a bland information memo was issued which didn’t say very much but satisfied nearly everyone. It contained some historical statistical information and gave the impression to Sprague that F. S. Moseley was indeed doing its part in following the stock. The clients could read into it that, after all, the firm wouldn’t be putting out a report if it felt things weren’t going pretty well, and I was satisfied that I had not published the requested buy recommendation. The problem was that the report did not accomplish any useful purpose in giving someone investment guidance.

Institutional investors dominate the commission structure. About $7 billion is spent annually in commissions and investment fees, the bulk of which is in commissions related to transactions. Large institutional investors with perhaps $200 billion in assets have replaced the wealthy individual as the chief source of income for most brokers. The power to direct commissions and transactions, far greater than was held by the legendary robber barons of the past, is now in the hands of fairly junior institutional employees. They will reward brokers for a multiplicity of services, some obvious and some subtle.

Stories abound of liquor and girls being used to attract commissions. It must be a sad commentary on my image that offers of that nature have never been made to me, and I am unable to report some of the sexier sides of the investment activity.

I have mentioned that brokers tend to pander institutions by complimenting them on things which the institution has already done. Moreover, the trend of communication between broker and institution has changed tremendously and such change reflects structural shifts within the business itself.

As institutional investors became more intense, performance-oriented, and less conservative with capital during the fifties, a new type of broker was spawned. The archetype institutional firm was pioneered by Donaldson, Lufkin, and Jenrette—three bright, young, well-experienced Harvard Business School graduates. Their contribution to the evolution of investment practice was the development of in-depth reports on unusually attractive industries and companies; typically companies large enough to be attractive to many institutional investors simultaneously but companies that were not exclusively big.

They would claim to have more knowledge of that company or industry than anyone else. They went well beyond the demands of many investors at that time, which were only for information that was contained in a company S annual report and a Standard & Poor’s tear sheet. After all, how much information did one need to supplement a large institution’s knowledge of IBM, Standard Oil of New Jersey (later Exxon), or General Motors?

There was a growing need for such information and DLJ capitalized on this requirement. The companies they sponsored and followed prospered during the last third of the bull market, while the company itself prospered for its innovative activities. They pioneered the brokerage report of fifty to a hundred pages, which could be used as a file document giving evidence that the institutional investor had prudently examined the investment alternative far more than he could have by any other service. In effect, DLJ fired at their target companies with a high-powered rifle equipped with telescopic sights rather than blazing away with a shotgun at anything that moved. The information was persuasively presented, well documented, and provided both depth and breadth to a fundamentally oriented investment decision. Dozens of firms imitated this practice and many succeeded in establishing, for themselves at least, an equal place in the eyes of institutions for in-depth service.

As the pace of the market quickened from the mid sixties, the time required to thoroughly research, document, and distribute detailed information proved inadequate for performance-hungry institutions. Increasingly, results had to be conveyed to institutional investors before the final report was completed. While it was being prepared, brief summaries of recommendations would be disseminated, or salesmen who maintained a close contact with their own research department would verbally convey the information that was to come later in the full-dress report.

The recipients of the advance word were consciously aware that future buyers, on the basis of the tailor-made report, would push the price up or that institutional investors would buy on the sketchier advance information. What actually happened was that information demands receded to the point at which commitments would be made, with some understanding that insurance for success would appear later in the form of a more detailed report that would spark buying pressure from the slower-moving institutional investors.

The individual investor, meanwhile, was caught in the backwash of both vessels. Not only did most brokerage firms separate their research departments into two groups—institutional and retail (with the better analysts going to the institutional area)—but it was general practice for retail analysts to pick up ideas from the institutional analysts after they were discarded or exploited. The retail analyst would get sufficient documentation presumably to attract a retail customer. Evidence of a rising stock price would be part of the documentation that the idea was good for a retail buyer. This early start would have been created by initial moves of the aggressive institutional investors.

This situation was the "greater fool" theory in action. Three levels of investors were being served by the institutional broker: the institutional investor who would move on sketchy advance warning knowing that a report was to come; the institutional investor who required the detailed report—often a bank or trust company that would find it difficult to add a new name; and the retail customer at the end of the line.

This practice was effective in the mid to late sixties when the bull market topped out in an orgy of speculation and new issues that ended in 1967. The volatile markets that have ensued since then, where the Dow Jones Industrial Average has ranged between 600 and 1,000 and the average price decline on the New York Stock Exchange has been more volatile—falling about 70 percent, have created a different character.

Brokerage firms no longer tout the performance record of their recommendations and the likelihood that they will produce instant or ultimate success. The move by brokerage research departments to institutions has been in the direction not of recommendations but of "service." We have had the phenomenon created throughout the late sixties and early seventies of the so-called one-decision stock—a security of superlative quality and persistent earnings growth that one wished to hold perpetually. Since all brokers and institutions can identify these privileged Securities, there really is no point in recreating long, detailed reports that delve into the history and industry structure of, for example, some of the leading drug companies. This work has already been done so many times that it has been accepted for many years as being redundant. If the names that institutions wish to have in their portfolios are known, what can a brokerage firm do to attract commissions from large institutional shareholders?

Within the notion of service comes the objective of closely following a security, that is, reporting corporate events more quickly than other people. This may not be directed toward specific transactions, buy or sell, on that particular security. Rather, the reporting of events allows the institutional analyst or portfolio manager to appear well informed. To the extent that portfolio and stock price changes may be at least random for highly institutionalized securities, the timely knowledge of company news may serve one S own career. There should be no surprises in a portfolio so that price changes can be ascribed to outside environmental forces, not to analytical sloppiness. Service, then, is not necessarily directed toward building portfolios that are more profitable, rather it is built around protecting the job interests of the individual who distributes the commissions.

To the extent that the allocation of commissions also supports the job security of the people in the brokerage firm, one has the impression of a business alliance for convenience. Of course, the only sufferer is the client who may be paying high management fees and commissions for activities that are not related to decisions that will favorably influence his profits.

There is a wide variety of brokerage reports and services available to institutions. At the more expensive level of service are consultations with economists, technicians, and political observers. These establish the general scene from which investment decisions will be made. Most institutional portfolio managers have now repudiated the value of stock selection and feel that the only things which are going to affect their results are the macrointerests of whether or not to be in the market and, if so, in what sector.

Stock selection can take care of itself through junior people in the organization or, for that matter, it may be taken at random. This proposition is valid only as long as all investors emphasize stock selection. Securities may be very closely and accurately priced by other investors. It is possible to plagiarize the stock-selection techniques of others by merely accepting today’s price on the securities one wishes to buy or sell.

The next level of service by a broker for institutions will be to have the best, or nearly the best, analyst for a particular industry. Nearly all institutions want to have access to industry specialists.

The best type of brokerage report, in my view, for an institution is that which identifies the critical variables in a technical or fundamental decision and assigns weights to these variables (in such a way that the institutional analyst decision-maker can change the weights if he wishes) and shows the conclusion that the brokerage analyst reaches and how he gets there.

A report prepared on Polaroid in 1972 by E. F. Hutton & Co. was one of the best I have seen on the company, yet it did not contain a single narrative word. This report (Figure 1, pp.36-9) isolates the critical ingredients to determine Polaroid’s profitability.

INSTRUCTIONS FOR CHARTS

1. Select values for the items listed on the Work Sheet and note them under the appropriate years.

2. CHART 1A—Draw a straight line connecting projected 1973 Aladdin Camera Sales ¬ and First-Year Usage ­ . The intersection with vertical line ® is connected with the Attrition Rate ¯ by a straight line. Film Sales (in millions of packs) resulting from 1973 Camera Sales for the calendar years 1973-1976 may be read off this line where it intersects the appropriately marked vertical lines ® , ° , ± , and ² . These figures should be noted in boxes below the Chart as shown by the heavy dashed lines.

3. Repeat Step 2 for Charts 1B through 1D. Note calendar year Total Film Usage figures in the appropriately marked boxes. Add the figures. The "TOTAL" shows film pack sales in millions in each calendar year.

4. CHART 2—Aladdin Camera Sales—Draw a straight line connecting Cameras Sold this year ¬ with the Average Dealer Price per camera ­ . The intersection with vertical scale ® will give Revenue derived from camera sales. Connect that point with expected Operating Margin ¯ . The intersection with line ° directly gives Earnings per Share resulting from camera sales. Note the figure in the box below the Chart.

5. CHART 3—Aladdin Film Sales—Total Film Sales for any year is obtained from the boxes accompanying Charts 1A, 1B, 1C, and 1D. Use this total figure on Chart 3, Line ¬ . Connect with anticipated Operating Margin ­ to obtain Earnings per Share derived from total film sales ® . Note the figure in the box.

6. CHART 4—Impact of Kodak on the Type 108 Market—If you expect Kodak to be competing for the conventional Polaroid film market (Type 108/88) during the year under examination, connect Total Market Size (Type 108/88 film only) ¬ with the Market Share expected to be taken by Kodak ­ . Line ® will provide Earnings per share of market. If you do not anticipate Kodak’s market entry, use 0% for the Eastman Kodak share to obtain Polaroid’s earnings on its conventional film product. Note the figure in the box.

7. Add together the three boxed figures to obtain total Polaroid Earnings per Share for the year under consideration. An additional 40-50 cents per share, resulting from non-amateur activities and interest income, may be added to obtain total corporate earnings.

Since nearly everyone studying Polaroid has his own ideas as to pack usage per year and number of camera sales in different price brackets, building up the income statement becomes an exercise in which anyone can plug in his own estimates and relate them to the various stages of fixed and variable costs.

The other type of brokerage report, which receives far more publicity, is the sell report of an institutional favorite—most likely caused by an earnings estimate reduction, by an analyst who has been closely identified with the security. The sharp price declines of institutional favorites like Polaroid, are often caused in the short run by this falling from favor with analysts or brokerage houses which have been strongly identified as the critical sources for information.

When a company from which a great deal is expected produces a down quarter in earnings or announces that earnings will be disappointing, a stock like Polaroid or Avon can rather quickly fall to a price 50 percent or more below former levels. Fortunately, many individual investors are not involved with these securities. It is mostly an institutional game where the volatility risks are understood.