On many occasions, I have attended meetings with a sponsor’s independent directors. The format is almost always identical—a review of performance, restatement of objectives, investment outlook, and questions. The questions are usually polite (but during the poor-performance period of many mutual-fund organizations, they are getting harsher). The questions characteristically involve looking down the portfolio list to see what was sold at a great loss and asking about safeguards to prevent such a blunder from recurring. Or, the portfolio will be examined for sources of unrealized capital losses and the portfolio manager will be asked why he is staying with such "dogs" when he could have bought more of the stocks in the portfolio that went up.

The independent director’s motives are in part financial; they are often well paid for this responsibility, although there is a question as to whether the pay is sufficient for the legal liability they may be assuming or for the prestige and information. A directorship involves, in most cases, spending a day probing around and getting the best thinking of an investment organization. Yet at no time does the system really serve the interests of the fund’s shareholders. One characteristic is that there has been only one occasion to my knowledge when the independent directors of a mutual fund have actually shifted the management contract from one sponsoring organization to another.

Investment organizations of all types have a very horizontal structure. They have not had, until recently, several management layers. Instead, they have operated more like a university with independent faculties and a dean, whose task it is to provide a fully functioning environment and the services necessary to support specialized faculties. The investment function is an intense emotional experience and one that would logically require rotation through different types of portfolios or into other parts of the business to maintain a freshness of spirit. Rotation usually takes place only when failure has been achieved.

In fact, one difficulty of large investment organizations is an inability to shift people to different functions. To be sure, portfolio managers may be transferred from one type of account to another—from a yield to an appreciation account, for example—or moved into the bond area. But rarely does this take place with corporate functions. Occupational rotation is done as a normal course for training the broad-gauged business executive. Rarely in an investment organization are there any transfers among the three aspects of the firm—administration, marketing, investment.

All investment organizations have very high operating leverage, although the apparent nature of the business is volatile, depending upon changes in market value. Fees are computed upon asset value or on brokerage charges for transactions, both of which tend to rise during periods of good markets and contract during poor markets. Most costs are fixed and do not vary with transactions. So profits are high during prosperous market periods, which encourages firms to expand at a time when they should be holding fast, and profits are low during depressed market periods. This is a service business with little need for fixed capital, except for preparing for poor years to come. The financial reserves for unfavorable years for brokers and institutions tend to be relatively small. Overall, the returns on capital for long periods of time tend to be exceptionally generous.

With the substantial operating leverage in this business, it would seem very odd to add financial leverage on top. On the other hand, brokers characteristically borrow a great deal of money and produce the worst possible combination of operating and financial leverage. This combination is perhaps one reason why brokers, as the spearhead of the investment business, experienced serious financial re verses in the early seventies.

Most large investment firms spend much of their time communicating. Decision-making is diffused among a variety of portfolio managers, analysts, and staff advisors, such as economists and traders. A single decision is often made by all of these levels working together, communicating the essential information required to make such decisions. Ego-involvement in any portfolio decision-making is quite high. At each level are highly skilled and trained individuals. Much of the effort of the organization must be spent in facilitating the communications flow. It is well known that a squad-sized group of eight to ten can operate quite informally but, beyond that number, status, strata, and formality take over. Morning meetings are essential for informing a large number of people about what is going on within the organization. The paperwork flow must be analyzed, with snap-out carbon forms going to individuals who may not be directly involved in the line of a decision-making process, but who must be kept informed in the event that they have to step into the process in an emergency.

Most large investment firms seem to spend most of their time communicating and very little in thinking or decision-making. Perhaps this is another reason why large investment organizations are loathe to make investment decisions. These monoliths believe in holding a portfolio that will behave in line with market expectations, while at the same time they pay ceremonial or religious lip service to practices of investment analysis or portfolio management that in the distant past have produced success.

In the most diffused investment institutions it is somewhat more difficult to determine precisely when an investment decision is reached and by whom. There has been a full swing away from the superstar days of the sixties to the market-portfolio days a decade later. Now, few decisions are made, objectives are modest, and a slow pace, organizationally, is followed. A defensive posture is demanded. This is a 180-degree turn from the mid sixties, when striving for top place on anybody’s performance list was the objective, and some took the extraordinary risk of placing huge assets into the potentially capricious hands of lone, untrained individuals.

I can speculate that ten years from now entire areas of the so-called middle management of investment firms will be replaced by quantitative operational tools with the principal decision-making being done by a few top-level people.

A great deal of the business of the investment community is conducted over lunch, which may be the most important session of the day. A luncheon meeting will typically last an hour and a half to two hours and may include a forma] presentation. Lunch is usually structured around one or more persons trying to persuade other individuals of another company or department to adopt the views of the first group.

One of the more common luncheon settings is a bank. Some of the more select private banks, or large investment banking houses, maintain excellent dining rooms for entertaining clients. Here the topics are more general, the evidence of papers at the table is considered gauche, and the menus will surpass even the finest restaurants in the city. Lunch will nearly always be followed by coffee and cigars where more specific "buttonholing" takes place if required. Boston is less noted for private dining rooms than New York, but the city has several first-class competitors in the race for culinary excellence. Brown Brothers, Harriman has long held the top spot, although a newcomer, Alliance Capital, a division of Donaldson, Lufkin & Jenrette, is competing for a five-star rating.

The message the host conveys to his guest is several-fold. He is saying that the elaborately prepared and served luncheon is the way the host lives all the time. Working with him—thereby hiring the host to manage the guest’s worldly goods—naturally insures that the guest too will live similarly well. Few guests react negatively. They seldom recognize that the host is allocating his resources to a chef, rather than hiring one more senior analyst.

Under some conditions, the public display of ostentation has backfired. The typical old Boston trustee will maintain an office in dingy, dusty quarters and drive home in a rattly old Ford, while controlling assets of hundreds of millions of dollars. No client visiting him in his office surroundings would feel as though the fees were being misapplied, whether or not such was the case.

Keystone built an elaborate building at a time when mutual funds were under attack for having excessive fees relative to the performance and satisfaction received by its clients. Atop the building, it put its trademark, advertising to the world that it had enough money to pay for real estate, but did not have enough at the present fee structure to hire additional people to improve the results of assets under its care.

Brokers have been especially susceptible to the idea that clients will associate elaborate office quarters with success and that this will be a marketing aid. The expensive offices and leasehold improvements acquired by brokers in the last ten years may be more responsible for their demise than any other single force. An old-line, respected, well-capitalized firm—Clark, Dodge—built the most elaborate brokerage office space in Boston in the tower of the new First National Bank building. For two years the office was less than half filled. The firm was unable to acquire new salesmen to fill these opulent surroundings. Whether the clients reacted negatively to the surroundings, I don’t know. It is more than coincidental that Clark, Dodge was recently taken over on knockdown bargain terms by Kidder Peabody, which maintains crowded offices in an old building.

The broker or investment manager who thinks that lavish surroundings and luncheons are conducive to a professional relationship should be reminded again of the expression: "Where are the customers’ yachts?"

Selecting an Investment Firm

Individuals and tax-free institutions seek investment managers in a different format, although their fundamental reasons may be the same. They want to trust the people they select and they expect efficiency. That is, they want higher returns than average at an acceptable level of risk.

The first clients of most new firms are individual investors, as opposed to institutions. They usually are not very sophisticated about investment techniques but are accustomed to judge professionals by the look in their eye, the manner and sincerity of their approach to the client’s problems, and by matching their own personality against the professional. The client wants a professional investment manager who will behave as the client would himself if he had access to the same information.

The decision-making process is relatively swift. The unsophisticated individual does not enjoy talking with many professional investors. He frequently does not know what specific questions to ask, but he does know that his decision will be based upon factors other than those that may relate to the investment activities of the professional.

Credentials are important; they at least give evidence that original skills are present. But more directly, one has a feeling that the decision is made quickly in an interview session and on the basis of intuition far more than from an objective check list. The early clients of our new firm tended to be individual investors and, since even our smallest accounts were quite large, they obviously were people of wealth.

Few individuals open an account with a relatively new firm for their first investment-management experience. We saw investors who were on the rebound from other investment activities.

These investors were of two types: individuals who had been with banks who, because of the size of their account in comparison to the large trusts, found they were being shuffled frequently between junior trust officers; and secondly, individuals with engineering or scientific backgrounds who thought perhaps that our investment approach was more quantitatively oriented and less mystical than others.

The typical individual is directed to a new firm by a friend or sometimes a broker. The recent investment record of the prospective manager is important. Few investors can make the act of faith required to choose a new investment manager whose record has been poor. Several visits may be involved; in fact, they are desired.

The initial visit establishes the base. The interval between the preliminary and the concluding session gives the individual time to think of new questions and to assign in his own mind a priority of the strengths and weaknesses of the investment firm he is considering.

The format for large tax-free institutions has evolved into a set pattern. These institutions are accustomed to splitting their funds among as many as twenty, but more likely half a dozen, investment managers. The early form of splitting was based upon the notion that competitive assignments of assets would produce better investment results, and the account would be split initially into approximately equal parts.

Subsequent experience has disproved this competitive-capital approach. We have discovered that the investment manager cannot escape from his specific investment-strategy mold, even if he tries. The sense of competition of variance in fee schedules makes little difference to the results that will be achieved by any one client versus another. Accounts now are attempting to split, in order to diversify investment styles and strategies and to pick the manager best suited for a particular investment approach. It is hoped that, by blending the best of high-yield, high-value, fad, or institutionally acceptable securities, one can get diversification and better results. Each style is expected to have some selection ability within its defined strategy, with a result that will produce better figures than a purely random sample drawn from each of the defined styles.

Initial lists comprising as many as a hundred potential candidates will be drawn from the reputations and hearsay as to which is doing a good job. A search committee will be formed that can be the same as a pension committee in a large company, or a finance committee for an eleemosynary institution. It is customary to send questionnaires to prospective candidates, designed to illuminate the differences among firms. Questionnaires are usually a dozen pages in length when completed but they include mostly the same questions.

Batterymarch receives several dozen questionnaires a year from large pools of money searching for investment managers. The questions are almost always the same: how large are you, how many accounts do you have, how are you organized, how do you reach investment decisions, what is your performance and so on.

Most such questions get relatively standard answers from us and other respondents. They do little to define the principal differences among firms, but merely provide a factual basis for confirming decisions that have already been made to accept or reject.

An exception to the rule of preordained decisions was one widely circulated questionnaire by the newly formed Harvard Management Company in its quest for outside managers in 1974. It illuminates factors one institutional investor considers significant about another. The questions they asked are as follows*:

* Reprinted with permission of Harvard Management Company, Boston, Massachusetts.

COMPANY BACKGROUND AND OPERATIONS

1. Name of company

2. Year organized

3. Ownership

4. Affiliated companies and relationship

5. Number of accounts with full discretion by size and type currently managed by your firm:

What was the number of new accounts acquired in each of the years 1972 and 1973 and their asset value?

What was the number of accounts lost in each of the years 1972 and 1973 and their asset value?

What is your firm’s minimum-size account

a. With positive cash flow?

b. With no cash flow?

Does your firm manage any mutual funds?

6. Management fee schedule. Please describe any exceptions.

INVESTMENT PHILOSOPHY AND POLICY

1. As we are looking for a number of complementary philosophies among our managers rather than a single philosophy, it would be helpful if you could outline your organization’s investment philosophy in some detail, including sample portfolios from the past two years to illustrate your approach. Please indicate how your philosophy may have changed over the past five years.

2. In addition, it would be helpful to us if you could comment on such investment policy questions as your attitude toward using market cycles, your time horizon in making investments and taking profits, what size company capitalizations you are most comfortable with, your principles of portfolio diversification, and your historical and expected portfolio turnover rates.

ORGANIZATION

1. A. Please indicate the number of full-time portfolio managers in your organization and include resumes if available.

B. Please indicate the number of full-time analysts, excluding clerical assistants, and include resumes if available.

2. Please attach an organization chart if appropriate, indicating flow of information and authority with names of individuals.

3 Please indicate what additions and subtractions of professional personnel have occurred over the past two years.

4. Please indicate how much of the typical portfolio manager’s and analyst’s time is spent on marketing and administration functions.

5. Please indicate the portfolio manager or managers who would be responsible for the management of a portion of Harvard’s assets. Please also outline his or her other current and projected responsibilities in your firm, including marketing, administration, and the management of other portfolios.

6. Is there any firm policy that would prevent your firm from working closely in a complementary relationship with Harvard’s internal management company?

7. Please indicate what the overall objectives of your firm are with respect to your future growth in general, and comment particularly on any present or planned areas of your business that you expect will be emphasized in the future.

RESEARCH AND THE DECISION MAKING PROCESS

1. Please describe the process by which an investment idea is originated, researched, evaluated, and ultimately becomes an investment decision. In particular, with respect to portfolio managers, please indicate what is the optimum number of accounts for each manager and what individual discretion with respect to overall philosophy or individual stocks he or she has in structuring portfolios with comparable objectives.

2. A. With respect to research, we are interested in knowing your sources of information and ideas about the general direction of the economy and market, the relative attractiveness of different industries and companies, and the relative emphasis that you place on fundamental or technical analysis. In addition we would like to know whether, and, if so, how, you attempt to quantify your estimates of potential rate of return; how you measure risk in choosing an individual security and structuring your portfolio; and what techniques of control and evaluation you employ to monitor your present and prospective holdings for buy and sell decision.

B. How big is the investment universe you monitor for possible new holdings and how many companies do you generate earnings estimates for internally.

C. What other techniques do you employ to develop or check investment ideas, which are not outlined in the questions above.

PERFORMANCE DATA

Annual change in per share (unit) at the beginning of the year for (a) all growth or balanced accounts under management, or (b) several typical growth or balanced accounts, preferably $10 million or larger, or (c) a public record growth or balanced account such as mutual funds or common trust funds. If you are able to supply (a), (b), and (c), please do so and note which performance is being supplied.

The questions can be summarized: who, what, where, how, how much? The results among the larger firms are not dispersed widely, as are those of smaller firms. Expenses can range from nothing, for someone who wants to make a price concession in order to get a lead account, to charges of one or two percent of market value.

The answers are usually amplifications of material that may have been published in brochures. But they can go into far more detail, since the brochures go through extensive legal clearance, and must necessarily be more general in order to remain up to date for several years.

The prospective candidate usually plagiarizes answers for other recent searches of large accounts. Following receipt of the questionnaire, the prospective large account reviews the material, usually with an idea of establishing the best candidate in each of the investment styles he wishes to hire.

It is not uncommon for a group to sit around a table and sort out the questionnaires in the order of their merit. This stage often determines the ultimate decision. On the basis of the written material and the record and defined style of an investment manager, the committee members can gauge quite well their ultimate choice. But the most intense individual activity is still to come.

Invitations for presentation, usually an hour in length, are sent to a selection of candidates. This session is usually referred to as the "semifinals." A team of representatives from the prospective firm are invited to the institution’s offices to make a presentation, which is not unlike the preliminary presentation that advertising firms make to prospective clients.

It usually involves a two- or three-man group, perhaps a senior investment-company official, a marketing-oriented individual, and an individual who might be personally in charge of the account in question. The presentation will be to a committee of the tax-free institution and is an attempt by both parties to see how the personalities fit.

The presentation is usually opened by the marketing representative who gives the firm’s history, the business objectives, and the types of people involved at the investment institution. The senior investment officer describes how investment decisions are reached and perhaps reviews the current economic and investment outlook.

The prospective portfolio manager then describes how he would handle the transition of the new account were he assigned to the task. The normal cut within a one-hour presentation would be thirty to forty minutes of formal briefing, followed by questions for the remainder of the hour. As many as six presentations could take place in one day. I often have the impression that they added little to the decision-making process, except that some firms, which had previously been considered to be high candidates, do not show up as well face to face as they do on the written material.

Of the twenty or so candidates making the formal presentation in the semifinals, perhaps eight or ten will be dropped. The remaining candidates will be visited by one or two members of the search committee at the home offices of the institutions under consideration. Of the final candidates, usually one out of two will be selected.

The process from beginning to end typically averages a year and involves an expenditure of man-hours by client and investment institution that easily exceeds one hundred thousand dollars. Some clients hire consultants to assist them with the initial screening, determination of objectives, and fact gathering. As in most fields, consultants who engage in this work have skills that range from zero to superior.

One of the hallmarks of a true professional is the ease with which he conducts his affairs. He gives no sign of strain, although his output is greater than most others. He gives the impression of having ample reserve power to call upon in an emergency, but, never having to face an emergency, he can easily handle any problems that arise.

One portfolio manager at Keystone was responsible for his fund for over ten years. I never knew his educational background, but I suspected it did not include an advanced degree. Moreover, he was ten or fifteen years older than the graduate-school-trained portfolio managers who were taking hold. He had no great quantitative skills, and tended to work only half a day. His lunch was not a discussion of business problems, but was more likely consumed with one or two cronies from the firm at some no-name restaurant where the principal feature was inexpensive martinis served in a water glass.

Afternoons were not productive for this portfolio manager. If he didn’t make a decision by noon, he had sense enough to know that he should not make it in his afternoon condition. When the new group of scientific managers took over, this portfolio manager looked completely out of place. Regardless of his fund’s record, he was unable to explain why he was making certain decisions and made the process look as though he didn’t care. It was embarrassing that he worked only half the time and one could be concerned that he would undermine the morale of the younger men.

For reasons of technique, far more than result, the responsibility for his fund was transferred and he moved to another organization. In time, I began to realize that he was one of the most professional portfolio managers I knew. He had a universe of two hundred and fifty securities from which he had to choose eighty for his fund, His task, he felt, was to eliminate the hundred and seventy he didn’t want to buy. From an operational sense, this didn’t require full-time decision-making, and he didn’t feel up-tight about his job. He was quite relaxed, but it just did not look right in the demanding period of the sixties.

Another man who seemed misplaced was a mutual-fund technician. He might have had a high-school education, but I’m not sure. His entire approach to the market was completely mechanical. He used the rule of three, which said that if you took measuring calipers and spaced off distances on a chart (I was never sure if he used an arithmetic or geometric grid), you could forecast price targets for individual securities and market trends.

For some years he had been running mechanically selected portfolios, comparable to the Keystone portfolios. His mechanical hypothetical portfolios invariably outperformed the real accounts, although one could hardly ever understand why. It seemed to smack of examining the rooster’s entrails in the morning at the temple but it worked. He never seemed to experience the same indecision about the future that plagued the rest of us. He could examine his scrolls and tell exactly where we were. No one used his technical service and eventually he retired.

Client/Investment Firm Communications

Some clients have no desire to talk to their investment manager. Once they have delegated the responsibility, they prefer to have no further thought about it, especially when it is painful. With these clients, under adverse conditions, manager and client behave in exactly the same way; they have no contact until things get better and conversations can be more pleasant. It is our normal practice to communicate with clients on a monthly or quarterly basis. We have a church group that said it wanted only to be informed of the investment situation every five years. I assume that they are looking into their investment performance over a very long time, once every generation. We have, in this case, communicated quarterly.

Other clients want frequent discussions with their investment manager, i.e., weekly calls, discussions about the impact of specific events on market prices, and general attention to short-term information. I have seen no indication that such a stress on short-term communications is productive for anyone. It is the type of communication that many individual clients are accustomed to having with their broker, and it relates far more to a trading philosophy than to an investment-management activity.

When times are good an investment manager is frequently inclined to write his client and say "the numbers speak for themselves." But writing that type of letter is risky in a bad quarter, for the client may return a copy with a postscript added: "Send me my funds."

There seems to be an inverse relationship between the length of an investment manager’s letter to his client and market performance. When conditions are poor, the manager has to go to greater lengths to point out that some of the loss was due to bad luck, that the part that was due to poor skills had been corrected. When good results stem from generally favorable market conditions, few managers feel compelled to write long explanations about the mistakes that were made that did not show up because the rising market itself bailed out the error.

I have extracted portions from client letters to illustrate the tone that is taken after different market performances. The letter covers the general outlook for the economy and the market, a review of past results, and a forecast for the future with an outline of what sort of portfolio action is likely in the next quarter.

The letters were written to sophisticated individual clients:

Date: April 1974 Good Results

"…In terms of comparative market performance, this quarter was very satisfactory...

"We have continued to emphasize defensive earnings. Government economic figures suggest the recession began in November 1973. The recession is likely to measure between average and mild, perhaps not dissimilar from the 1969-70 period. It will be characterized, however, by sharp differences in results with some industries operating under boom conditions and others under stringency. Profit levels for the year may be higher than our original forecast of flat to down slightly. Price levels in the industrial sector are rising fast enough to absorb the slippage in unit costs and small gains of volume. The industrial raw material price increase of over 60 percent worldwide last year should steadily moderate its rate of gain as the year continues…

"You will be interested to know that the average earnings per share gain of your portfolio approximated 20 percent. More importantly, we have selected companies during the past year for their characteristics to do well in a recessionary year. Although we might expect mild gains in corporate profits in 1974, our current forecast is that your portfolio earnings gains will be five percentage points higher. We believe this difference as well as the higher-than-average yield should make these companies comparative standouts as the year progresses...."

Date: April 1972 Good Results and Preparation for Poor Market

"Your account stands at nearly $4.5 million at the close of the quarter, a reasonable milestone since we started at just slightly over $3 million in the middle of 1970. In percentage terms, the results have been greater adjusting for the account withdrawals. The percentage increase of 10 percent versus some 5 percent in the Standard & Poor’s 500 Index would not have been possible in the first quarter except in a favorable environment. We have, however, been reasonably risk-conscious throughout the period and the resistance of the portfolio in earlier down market periods suggests that we may do reasonably well if the market declines now.

"Approximately one quarter of the portfolio was sold and reinvested in securities that serve a ‘two-hat" function—securities that will likely do better than the market whether up or down. The sales were made principally on those items that had, on average, a 50 percent profit where we no longer considered the securities to be unusually good values....

"By any historic measures, the market is high. The yield spread between the Standard & Poor’s 500 Index and long-term bonds is almost five percentage points, the market has become progressively more speculative during the quarter, and it is more difficult for us to find security ideas at a reasonable price which appears as attractive to us as opportunities were during 1971. We are responding to these conditions by reducing the cyclical exposure to less than half of the portfolio and looking for opportunities to increase more defensive areas like regional banks and life insurance, where opportunities exist to satisfy our growth and earnings-multiple criteria. We have no plans to carry a large cash position but do plan to adhere rigorously to our practice of taking profits wherever they occur. Essentially we have done better in a rising market than I would have forecasted, and we are currently trying to build into the portfolio characteristics that protect these gains. I have no clear market forecast but have a hunch that the end of the year may be softer than the early part of the year."

Date: July 1973 Explaining Poor Results

"…This seeming lack of resistiveness to a generally used market index has surprised us and precipitated a reexamination of our strategy. I know you will be interested in the results since we were attempting to answer the question on what modifications, if any, we should make in our basic investment approach.

"The average decline of all New York Stock Exchange stocks for the first half has been just over 30 percent this year, and your account has declined by 20.8 percent. Painful for us is the relative success of the Standard & Poor’s 500, off only 11 percent. We have found, the hard way, that one cannot tie short-term performance to the S&P 500. It has become so weighted by growth stocks that it behaves like a growth-stock index, increasingly independent of the mass of stocks.

"Fortunately, our selectivity against the mass of stocks has remained. For all accounts, our lead over the average move of all NYSE stocks has been:

1970 +11.9% 1971 +7.1% 1972 +9.1%

Six months 1973 +12% annual rate

 "Investment gains from this level could be unusually high. The ratio of the mass of stocks to the senior 100 has always reversed from similar depressed levels. From current overselling due to loss of confidence, multiples could recover over the next few years in the range of + 10 percent to +40 percent. Probable exceptions would be most of the growth stocks currently at peak multiples. Present portfolio yield of 5 percent is itself a good return. Real growth of the economy is likely to remain slightly over 3 percent in future years. Corporate profits despite lags have historically held inflation, which is likely to run at 3-5 percent. Our selectivity remains at 9 percent, but even if it fell to 3-6 percent, this could result in a total estimated appreciation of over 15 percent a year.

"This analysis leads us to the conclusion that it is possible to make discriminatory judgments from our market universe and, although we have seen a most unusual market, we are presented with the time in which our approach should be most valuable. The principal question then becomes not so much what has happened, but do we own the correct securities for the next phase?…

"The market decline in the past quarter, painful as it has been, has given us an opportunity to increase the expected total return of your portfolio at prices in relation to value unseen for two decades. That we have been able to do so and increase the income yield seems all the more unusual. Our program during the quarter has not been a radical change but has involved the sale of some securities that were cheap to buy others that were even cheaper and had better historical growth rates."

Date: October 1974 Culmination of Two-Year Sharp Bear Market

"…There are two paramount questions. First, will the market decline further? Second, does the extent of the decline presage a depression as it did forty-five years ago?

"Two years ago, we expressed the view that 102 on the S&P 500 was very high and we expected our selectivity skill and lower volatility than most investors would give our accounts comparative resistivity—if required. This relative resistivity was accomplished. But the extent of the decline was unexpected, influenced as it was by a number of events that were entirely unforeseen by us and most others: 12 percent interest rates, 10 percent inflation, oil crises, stalled government, and international financial strains. A few things are happening as expected: a mild recession, an increase in investor appreciation of yield, a correction of speculative excesses in normally investment-grade securities, and a continuation of Batterymarch selection skills of several percentage points a year against a random selection of all stocks. We have gone on a journey we wish we had avoided but, having done so, we are reluctant to leave the wagon that has always before made the return trip.

"Market technicians, who I believe have a good sense of market history, tell me that the normal three downward waves of a decline conform to anticipation of problems, appraisal of current problems, and the most unpredictable phase—an emotional liquidation that seemingly defies quantification. If this breakdown provides a guide to where we are, we passed through the reasonable-value stage earlier in the year. Prices now are dictated by the forced liquidation of individuals and institutions saying that no further declines can be withstood, even if the odds would favor a reversal. Furthermore, investment managers may be frozen into inactivity by threats of job security and a pattern of ego-shattering decisions in the past couple of years. The combination of noneconomic-induced selling and hesitant potential buyers produced a third stage decline of determinable character but indeterminant extent and duration. To the extent that this last phase has plunged prices well below those hoped for by the classical value-oriented investor, unusual once-in-a-generation opportunities exist. After all, we have already paid for once-in-a-generation risks.

"Most institutions have acquired at least double their normal cash positions. If a 10 percent cash position was held two years ago and the equity account declines by 50 percent or so, the cash is now 20 percent without making any assertive sales. In many institutional accounts, there is some cash flow, which by manager preference or client dictate, will not be employed until ‘conditions seem more secure’. The nearly unanimous consensus view is that these cash positions can be reduced promptly whenever investors all see the same secure signs. Estimates on the size of temporarily sidelined cash vary but the magnitude is easily in the tens of billions.

"In dealing with the central issue—to invest in equities or not, and if yes, how much—we can summarize our views as:

1. We don’t know when or where the decline will end, but it seems to be overdue and overdone by most historical and fundamental standards.

2. More so than at anytime in Batterymarch’s history, our portfolios seem to have exceptional investment potential.

3. Institutional cash levels are being determined more by psychological conditions than economic necessity. These levels can be subject to extreme change."

We send detailed, quantitative reports to our clients that stress almost any aspect one wishes to study. Portfolio values are unitized like a mutual fund so that they can be compared in performance with standard market indices with income added in, as well as with published mutual-fund figures and most of the figures used by other investment managers.

Percentage results of gross account values are so misleading as to be useless for performance determination because there always is some cash flow in or out. Since most investment managers are oriented to tax-free accounts, total return or the sum of appreciation and income without adjustment for taxes is the appropriate measure.

In addition to the detailed performance track, accounts are presented in the conventional balance-sheet way, with a breakdown by type of asset, industry, estimated income, and the like. Some investment managers, like ourselves, highlight the differences between cost and market, showing in clear form unrealized gains and losses. There is no doubt that such procedure accentuates the impression of good results under bull-market conditions and poor results in a bear market.

This illumination further accentuates the likelihood that investment managers will eliminate their losses so that they fade out of sight, rather than become continually festering sores in the client-manager relationship. An investment manager can make a loss disappear, although overall performance will continue to be penalized by the amount of loss that is taken.

The face-to-face meetings with investment committees of institutional clients are especially intriguing. It is frequently an adversary proceeding when the client feels he must pick up the flaws that are present in every portfolio. From the manager’s standpoint, it is a salesmanship activity to renew a client’s confidence in the fact that the high objectives that were originally established are likely to be met if only patience will be exercised.

Some of the most interesting meetings with clients take place in the first days of a new management activity. Shortly after Batterymarch was selected to manage the endowment for a private school, the regular quarterly meeting of its investment committee was held at the University Club in New York. The account was split three ways: part to the Common Fund, the newly established co-mingled fund for small educational institutions; part with T. Rowe Price, with its emphasis on institutionally acceptable growth stocks; and part with Batterymarch for our low-multiple, high-yield, value orientation.

The finance committee had two sections. One consisted of ladies who were graduates of the school, largely the benefactresses in the alumnae-giving program. They were influential in setting the tone for the trustees but were not especially familiar with the investment process. The second section included men who were engaged in some aspect of the investment business. One was managing partner of a brokerage firm, another was president of a large mutual fund, and so on.

Batterymarch had converted a cash portfolio into one with a 60 percent securities position, most of which were unknown names in relatively mundane industries. In our opinion, the securities offered the best combination of value at low risk.

One of the influential members of the committee was an elderly Wall Street lawyer. From the end of the table he watched me enter the room and lowered his head to see my face over his half-glasses. His eyes narrowed, and as I sat down to arrange my papers, he said, "Mr. LeBaron, I hope you will tell me this morning about these speculations (stabbing the portfolio in front of him with a forefinger) you have purchased for our girls."

Considering that this was the first time I had met this committee and new relationships are always initially unsettling, I reached for a coffee cup on a side table to add some liquid to my parched throat. With more than the normal rustle of papers, I began my comments. "Gentlemen"—then looking around the room—"and Ladies. Before I begin with our outlook for the market and the economy, let me tell you that I will depart from my usual format. Let us; instead, just take every security we have put in the portfolio, as well as others we propose to add in the next several months, and discuss one by one the features which appeal to us."

I then proceeded to list each security and say approximately the same thing, because each one more or less matched our profile of selling below book value, at double the yield of the market, at half the market multiple, and at twice the rate of growth of the average security. I discussed the businesses that each was engaged in one controlled barge traffic, another was a water utility, still another was in building maintenance, and so on.

We dissected each one, taking more than an hour for this exercise. There were no questions; in fact, no indications that anyone was even listening. At the end of the session, the initial questioner looked up and said; "Mr. LeBaron, I haven’t seen such values since the early thirties. I didn’t know that it was possible in this raging, speculative bull market the youngsters have produced to find things like this."

Many other client sessions are not so heartening. In some, the investment manager has a feeling that nothing he does is right. In the light of our 20x20 hindsight vision, all of us have impressions that if we had done something different, it would have produced better results. These committee sessions tend to have a large measure of hindsight on the part of the committee members and rationalization on the part of the investment manager.

It is my impression that when confidence deteriorates between client and investment manager, it rarely returns and the relationship might just as well be terminated. Capricious switching of investment advisors is not only nonproductive, but may be counterproductive. It is very expensive for the investment manager to produce the extra effort required to become familiar with a new client. From the client’s standpoint, one portfolio is invariably sold and replaced by another with high commission and transaction costs.

Face-to-face communication seems expensive and at the time not especially productive. It is essential, however, so long as the investment manager feels he is providing both results and confidence. There seems no other way to achieve it.

Some client meetings are in a stricter format, usually a presentation to a group of six to ten. The following is an abbreviated version of one made to a corporate client in August 1974:

"The Vietnam War has just ended. The nightmare referred to in President Ford’s talk was thought by many to be Watergate, but it was Vietnam. After fifteen years of inflation, abuse of power, and deterioration of U.S. stature in the world, we have reached a conclusion to this terrible period. The dispiritedness and demoralization of the American people should soon absolve.

"In this talk I will cover three things: first, the macroissues, which at this juncture are going to be most important in determining the performance of the account. This will form a background for our investment strategy. It essentially describes the external environment in which you work in your business and we work in the investment field.

"Second, I will describe briefly our own investment philosophy. We are somewhat unique in our approach and much of what we do only makes sense if you can see it through our eyes. Our investment philosophy is, by contrast to the macro-issues, more the internal workings of the firm and recognition of the market mechanism. Much of the external environment in prices is discounted already at today’s market levels.

"We may differ from others, but I applaud the approach of those who pursue similar specialized, though different, tacks. We emphasize low risk, but that is due more to the stress we see being placed by others in high-risk areas rather than to provincial Boston conservatism.

"Finally, let’s see how we’ve applied our general posture to your account.

"In terms of macroissues, I think the times look very similar to the early twenties. There is a great degree of financial strain, as there was then. Business is likely to slow down modestly in terms of real growth because we’ve had an enormous bulge in the satisfaction of consumer demands. And there is a general desire for peace and quiet in this country.

"One of the very strong pluses this time, which may make the period we are entering different from the twenties, is that the Third World now has the wherewithal to satisfy its needs through higher raw-material prices. I’m sure many of you remember Barbara Ward’s Rich Nations, Poor Nations, which describes the ever-widening gap in wealth between rich and poor nations. That gap should now close, which would resolve a potentially unresolvable source of conflict.

"Inflation is in the forefront of all our minds. I expect it will remain in the 10 percent area and we’ll get used to it, just as it stayed in the 5 percent area after being at 2 percent. We became accustomed to that also. I don’t believe that inflation is negative for the stock market. It may be a neutral or a plus to the extent that equities are a call on real assets. But inflation does complicate business decision-making and it introduces a new element of uncertainty in business and investment thinking.

"In terms of a recession, I conclude that we entered a European-type recession in November 1973. Whether we started it because it was induced by tight money, or tight oil, makes little difference. King Faisal and Arthur Burns were in partnership. We’ll emerge from it sometime this year; perhaps we’re coming out now.

"This will be the first recession in this country with higher profits, although that has been the pattern in Europe with its steeper inflationary trend. The long-term trend that we keep in mind is that the United States is becoming increasingly like Europe. Certainly so in currency where the dollar is now just one of a number of world currencies. Social attitudes are being Europeanized with emphasis on more unionization, on holidays, work rules, and the like.

"In politics we probably will enter a period of legislative-dominated government, slower real growth—likely to be on a 1½ to 3 percent pattern rather than a 3 to 4 percent pattern—with emphasis on quality of life in the West and standard of living in the Third World. Inflation rates should range between 5 and 10 percent with more clustering near the higher than the lower end of that range. Finally, I think the stock market will do much better in the next five years than it has done in the last. I see no reason to change the same forecast I made five years ago for an inverse relationship.

"Our own investment philosophy relates to market efficiency and market capitalization. We emphasize stock selection in the size category just smaller than that which is dominated by institutional investors. We concentrate on individually owned securities that are institutionally acceptable.

"We consider that institutions are great experts at pricing securities, but that individuals are less well informed and have less acute judgment. We are searching continually for unexploited values, stocks that seem perhaps 30 percent undervalued compared with others in their own universe. We imagine we are buying the entire company. If the price rises to normal value, the security becomes the candidate for a sale. Now it may have a random chance of going up or down.

"We operate this way principally for low risk; secondarily, as a way to make money. The opportunities for money making in this activity are greater now than at any time we have seen over the past five years. This is because of the enormous disenchantment with what is called the second tier. We are very price conscious and we look at things like discretionary cash flow instead of just earnings per share, which may be the accountant’s guess of what future cash flows will be like. Companies that fit both the economic framework and our own philosophy are the ones that will find their way into the portfolios we manage.

"Let’s deal with your portfolio specifically. We have been operating for two months and are now 70 percent of the way toward a complete transition of a Batterymarch portfolio. That is on target, as we generally like to take something on the order of a quarter to complete the transition. Normally, we would have moved a little faster, but in this type of sloppy market, the markets have been thin and prices have been deceptive. There has not been as much depth to the prices as we like. We expect the portfolio to be equity-oriented, as the expected total returns are much higher in equities than in bonds. A 9 percent bond and a 10 percent inflation rate sound to me like a backward step.

"The portfolio is balanced—50 percent cyclical and 50 percent defensive. This is slightly more in a cyclical direction than our composite portfolio, but at this stage of the recession, looking to the future, we are building up the cyclical aspect of other accounts to match the posture we have in your account. Three months from now, or by the end of 1974, I expect to be 60 to 70 percent cyclical, with the remainder defensive.

"Within the defensive area, banks and insurance, traditionally a strong area for us, are 15 percent. We would normally be larger than this, but there are a number of imponderables about the financial condition of banks and insurance companies that we are attempting to grapple with. But market prices, in my view, should more than compensate for the imponderables. In the next month to six weeks, I expect the bank and insurance position to move up into the 20 percent area. Cash in 7 percent, which is slightly lower than our target at this juncture of 10 percent. The target yield is 6.3 percent, or almost double that for the market as a whole. If we take a return on cash as well, we come up to better than 6-1/2 percent.

"The portfolio is priced at 5.5 times latest twelve months’ earnings, or something less than the average stock, which is about 7 times latest twelve months’ earnings, or about half as much as the S&P 500. The rate of growth for the past ten years is about 10 percent for the portfolio as a whole, or about double that for the entire economy.