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WHAT MAKES AN INVESTMENT MANAGERGOOD OR BAD?I. Introduction What distinguishes the strong investment management organizations from the "also rans" and "only once rans"? Which are likely to be winners in the decade to come? In preparing this lesson, we drew upon the past seminars hosted by DLJ, seminars on managing the investment organization that were sponsored by the Institute of Chartered Analysts, and some literature and notes accumulated over the years. One obvious question is What criteria should be used to make such a distinction? Business performance has not always been synonymous with investment performance. The number of successful businesses among investment organizations is fairly large after this long, glorious period of growth in financial assets. But a list of consistently successful, superior organizations, as nominated by investment professionals, would be fairly short, with many names mentioned repeatedly. We will use client retention and people retention, as well as investment performance over a fairly long period of time, as the major criteria. True, the period of time cannot be all that long, because the business itself as we know it is only a little more than 0 years old. And within that time frame, many organizations have slipped off such a list while a few, re-energized and reborn, have lost and regained a high ranking after experiencing some dark days.
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We are going to approach the subject in two doses, the first section (I-VIII) address some of the broad principles and apparent lessons from the past, and the second section (VIII - XIII) provides a speculative look into the future.II. Characteristics of the Superior Firm First of all, in reviewing our collection on this subject, what emerges is that there is no single model for the outstanding organization. The shapes and sizes vary along with their breadth of business. Some companies are diversified while others remain narrowly focused. Some are still dominated by a single, strong leader, while others exist essentially in partnership form. All place a clear priority on their clients interests. They share deeply held convictions and values. There almost always is a powerful commitment to (1) excellence, () innovation, and () a free flow of ideas, and a correspondingly powerful resistance to bureaucratic obstacles. The great organizations establish and articulate clear goals, beginning with their business mission. Their philosophy is important to themselves and to others, but is not closed or inflexible. They tend to concentrate on what they do best, generally keeping their business simple, although many of these organizations are often on the cutting edge of new products. They focus efforts on being very good at their primary business and at least reasonably good at whatever lines they have diversified into. They reflect a willingness to learn and an urge to tinker, and they pursue good communications with their clients and their own people. The good ones control their growth and subordinate profits to the goal of satisfying their clients while keeping their own people happy. They are selective in choosing their clients and are willing at times to say no to new business. They enable their talented people to flourish by leveraging their skills while fostering and maintaining a creative environment. They maintain a good performance record by continually exercising some form of discipline.III. The Business Mission When we talk about the superior company having an overriding mission, that mission is generally some variation on the idea of providing clients with a superior product or service, being responsive to their needs, and being important to them. The focus is outward to the clients, yet there is never an effort to be all things to all people. Professionalism and high ethical standards are never relaxed. Charley Ellis, who has usually chaired the DLJ seminars, admires the beauty and simplicity of J.P. Morgan's definition of his business goal "To do a first-class business in a first-class way." Most feel that if you have your priorities straight, most other things will fall into place pretty well. That is, if in serving your clients' goals and needs you also provide a stimulating environment and execute your mission with skill and enthusiasm, you are apt to have fun along the way, and should allow room for that. DLJ has always listed "having fun" as one of its corporate objectives, though by no means the uppermost. In the whole process, a satisfactory level of profits is likely to follow. Both Charley Ellis and the renowned advertising executive David Ogilvy like to remind their listeners of what Marvin Bower, the former chairman of McKinsey and Company, used to say "Any service business that gave higher priority to profits than serving clients deserves to fail." Unfortunately, that is a statement that has fallen into frequent disuse during the 10's. Among our materials on the subject of a business mission, we recollect hearing two that were quite memorable. One executive said that his goal was "to keep the prima donnas moving in the same direction by stressing a team approach and preserving a sense of humor." Another said that "my short-term business plan is not to screw up, and my long-term business plan is not to screw up, ever."IV. Performance Few people needed to be reminded, as they were again in 17, that outperforming the market or the S&P 500 is difficult, especially on a long-term basis. We could offer some reasons why beating the index was especially difficult in the 10's and may not be quite so difficult in the next decade; but for whatever reason, it has been hard. One observer noted a year or two ago that over the 0 years of existence of some 71 equity funds, only beat the S&P, and only six did so by 00 basis points or more. In fact one of the finest of the large investment organizations acknowledges that its primary investment objective is to outperform the S&P by 100 to 00 basis points on a consistent basis. That has been its historical record, and it believes that any expectation of doing better than that is unrealistic. A worthwhile goal, the realization of which would be considered a notable achievement, is to outperform the market in seven of every 10 years. The good firms tend not to shoot the lights out in the up markets but rather to preserve capital in down markets. And one reason the 10's has been so difficult is that it has been nothing but an up market. What is clear is that almost no one does better than the market year in and year out. Warren Buffett may be one exception, and many of those who, like him, are investment disciples of Ben Graham's value investing approach have done extremely well. An interesting article a few years ago in the Columbia Business School's quarterly, Hermes, told of how a group of prominent Grahamites -- Buffett, his partner Charlie Munger, the Sequoia Fund, Tweedy Browne, Stan Perlmeter, Walter Schloss, and Pacific Partners -- had decisively outperformed the market over time. However, with the exception of Buffett, each of these investors had experienced some poor years, and as a group (again excluding Buffett) they had underperformed the market 8-4% of the time. One, Pacific Partners, was behind in eight of the 1 years recorded, including one six-year stretch, but nonetheless over the entire period had beaten the average handily. Along the same line, the publication Outstanding Investor Digest, in showing the investment records in recent issues of some standout managers, revealed very impressive total compound return performances, and indicated that superior results did not come about automatically year after year Total Compound Return Manager (years underperformed) Manager S&P 500 Peter Cundill's Value Fund (5 of 14) .0% 11.8% George Michaelis Source Cap (6 of 1) 16. 1. Bill Sams FPA Paramount (5 of 1) 1. 1.0 Michael Price Mutual Series Fund (5 of 15) .6 1.0 Kurt Lindner-Lindner Funds (5 of 7) 18.7 10. V. People Obviously, the essence of a superior firm is outstanding people. Peter Vermilye, chairman of Baring America Asset Management, insists that only 10% of people add value and that mediocrity begets failure because it gets in the way of good ideas. The bottom 0% embody conventional wisdom, which is worthless, and therefore the average people should be weeded out. Certainly, special care must be taken in hiring, but what qualities do you look for? Talented investors are not necessarily brilliant, but they are shrewd and all share an intensity, a passionate interest in investing. Paul Miller of Miller Anderson & Sherrerd, and Art Zeikel, chairman of Merrill Lynch Asset Management, agree that good investors have a keen understanding of history, and can sense the tides and flows of events. They know how the market works and understand what makes stocks go up or down. Paul Miller called the business "the art of making money by investing on the basis of grossly insufficient information." The late Bennett Goodspeed, in his wonderful book The Tao Jones Average, noted that the skilled investor doesn't attempt to make a science out of investing. "He doesn't have the illusion of certainty where there is none and he doesn't try to make fixity out of flux." He knows not to overload information and recognizes that soft data is often more important than hard data. He is also forever aware of the constancy of change. By using his right brain he avoids becoming too logical and falling into the trap described by the late John Maynard Keynes, who said that there is nothing so irrational as applying rational solutions in an irrational world. One recalls Mencken's dictum that for every problem there is a solution that is neat, plausible, and wrong. An individual who is whole-brained is more able to question the obvious and to be irreverent in a healthy way. The famous advertising executive Charlie Brower expressed it well when he said, "the man who spendeth his life gathering folding money for the U.S. Treasury and has no fun is a sounding ass and a tinkling idiot." Peter Vermilye noted that one should be able to determine within a year whether an individual has what it takes or if the fit is wrong. It may take five years for that person to learn how markets react, and five additional years to learn how they react at different times. But if he doesn't have it, time shouldn't be wasted on him. Charley Ellis has said a characteristic error of investment management executives is to waste too much time on their weak people while not spending nearly enough time with their strong ones.VI. Structure Once you have good people on board, then the important consideration is establishing and maintaining an environment that enables them to flourish. The size and composition of an organization should depend in part on the particular investment style. Those with a trading orientation or emphasizing investing in small-capitalization issues have a special need to stay smaller. As Art Zeikel has written, the structure of an organization should depend in part on how you think the markets work. For instance, if you're an efficient-market theorist, that dictates a different structure than otherwise. But Art and virtually all experienced and successful practitioners believe that what is essential is to stay decentralized, to put the decision making and responsibility at the lowest possible level, and to keep the critical parts small. The decision-making process should be lean. The top people should stay involved in the primary business of the company and concentrate much of their effort on leveraging the abilities of their outstanding talents. Administration should be handled by specialized groups so that the maximum amount of the money manager's time should be freed up for the investment process and client communication. It seems to be a truism that good investment people are not usually good managers or administrators. The partnership form of organization -- as opposed to the corporate, which is so traditional in the large banks and insurance companies -- minimizes hierarchy and facilitates interchange and staying close to the client. The best firms have generally been those consisting of a talented group of people who like one another and share an intelligent investment philosophy. They can freely disagree intellectually but always mutually respect and trust one another.VII. The Investment Process Like the organizational structure itself, the investment processes should be designed to facilitate intelligent decision making. The superior firms make an effort to spend more of their time arriving at strategic decisions, and to recognize dominant trends, rather than emphasizing tactical and trading decisions. Performance is determined far more by asset allocation and sector decisions rather than by finding hot stocks. Yet often the best money managers arrive at those sector decisions by bottom-up analysis. Increasingly, some of the leading organizations ignore what economists or market analysts are saying. Warren Buffett says that he doesn't have an opinion about the stock market, the economy, or interest rates. He and other outstanding investors employ valuation criteria and disciplines that help obviate timing market decisions and enable them to fight conventional thinking. They also have the courage and ability to be inactive and not to feel the pressure of making decisions every minute. As Warren Buffett pointed out in one of Berkshire Hathaway's Annual Letters, the greatness of England in the 1th century was attributed by one of its prime ministers to masterly inactivity. As an investor, if you "wait for the right pitch" and buy right, you are in a better position to catch your mistakes early and eventually make sell decisions. Rather than permitting this piece to bog down in excessive detail, we'll put off until the next section reviewing how the good firms preserve their creative vitality and control their growth. At that time, we will also try to survey some of the directions the investment management business seems to be taking. The first part of this lesson discussed the characteristics of the strong investment management firm, concentrating on some broad principles and apparent lessons from the past. We also indicated that in this section we would take a speculative look into the future. But before attempting to do that, we also want to include some remarks on the role of a leader in an investment management organization and the importance of maintaining a creative environment while controlling growth. As was the case with the first half of this lesson, much of what can be said on the subject revolves around truisms but, since simple rules are so often violated, maybe they should be reviewed often.VIII. On Leadership The principles of good leadership can be applied to most endeavors and are virtually universal. In fact, Professors John Clemens and Douglas Mayer, authors of The Classic Touch, written in 187, document their contention that the major ingredients of effective leadership are well covered in our classic literature. The founder or successor/leader of a strong investment organization supplies some of these universal requirements by providing a guiding vision and establishing (or maintaining) a special culture. The good leader infuses his organization with his passion and enthusiasm while establishing high standards for integrity and setting an example of curiosity and daring. And yet along with that high energy and intensity, he also conveys the conviction that he is approachable and is willing and able to listen. One of the better definitions of a leader that we recall in our readings was the one attributed to Field Marshall Montgomery who said "A leader must have an infectious optimism and a determination to persevere in the face of extreme difficulties. A test of a leader is whether you have a feeling of uplift and confidence after leaving a conference or meeting with him." David Ogilvy, the advertising great, said that the leader of a creative organization "must have a strong sense of the unorthodox, symbolize innovation, and be a person who is never petty and never passes the buck. The strong leader doesn't suffer the crippling need to be universally liked, and yet is more nurturing than controlling." At DLJ's annual planning conference, chief executive officer, John Chalsty, noted that he felt that one of his major responsibilities in being the keeper of the DLJ flame was to show that he was caring, and that everyone in the organization mattered to him. One of the lines we liked in Max DePrees's recent book, The Art of Leadership, was that the first responsibility of a leader is "to define reality" while the last is to say "Thank you." IX. The Creative Climate Certainly a major responsibility of an investment firm's leader is to attract and retain outstanding people -- not merely clones of himself but essentially complementary personalities. To be able to hire and keep such talented people, clearly a creative climate must be fostered. While there is no one formula for doing so, management's attitude toward creativity is critical. For example, the leader must allow and encourage creative people to be heard and insure that they are always treated with civility and never exposed to ridicule. While the devil's advocate role is a necessary one in an operation, the leader or anyone else should discourage playing that prematurely -- especially if, as is desired, meetings involving brainstorming are conducted separately from those intended to reach decisions. Meetings, themselves, should be designed to foster interaction and interchange which could be facilitated if they are kept short and involve only a few people who sit or stand close together, desirably around a circular table. The purpose is to generate intensity and encourage constructive interaction. One positive dynamic in a more creative climate is a staff who are not all cast in the same mold. Ideally they would come from diverse backgrounds even though they share the same values so that the creative flare of some could enthuse and spark the imagination of others. The use of outside consultants, and flexible work and vacation schedules help too, but a management "dedication" to innovation and to the free flow of ideas is probably most important of all. The ideal holds the reins and manages -- as a Chinese philosopher once described how a fish should be cooked -- "lightly."X. A Peek at the Future If most of the principles relating to creativity and good management are enduring, then the well-managed investment firms should welcome the opportunities ahead in the next decade. But it is most unlikely to be a decade as glorious for enhancing financial assets as the 10's when institutions' financial assets grew 4% per year. While only in retrospect was it an easy period, those years witnessed an almost unprecedented and unlikely to be repeated celebration of financial assets. We have never had two great decades for stocks back to back. There can be a first time, but if it happens, it would almost have to come about via an upward valuation of multiples rather than because of strong earnings gains. We believe that the recent levels of returns on equity are unsustainable because an important part of the advances in recent years were due to lower corporate tax rates, increased leverage and widespread share repurchase programs. Those are largely one-time events and may even be partially reversed. In addition, we suspect that consumer spending, which comprises about two-thirds of GNP, will grow at a slower rate in the years ahead as the country becomes more savings and investment oriented. The case for an upward move in P/E multiples would seem to rest on lower inflation and lower interest rates, together with a general lengthening of investors' time horizons. We wouldn't be surprised if the payment periods for some of the excesses of the 180's -- the corporate leveraging, the real estate overhang, the thrift debacle and some of the ill-considered mergers -- were to encompass a year or two early in the decade; if that payback is not compressed in time, sporadic bouts of indigestion may recur in a more jagged and erratic fashion. That there will be a more subdued growth of debt and a much less shrinkage in the amount of equity capitalization seems assured. In fact, there may be some expansion in the issuance of shares as equity-linked securities become utilized in corporate reorganizations and restructurings. A number of corporate divestitures and LBOs could return to being publicly held companies as bankers apply their trade accordion style. Except for rescues, takeover activity -- especially of the big, hostile variety or transactions that are financially oriented -- should cool down considerably. Strategic mergers and those involving foreign companies, however, are likely to continue at the same fast pace. From the standpoint of economics, we might assume that European economic growth will be faster in the years to come than it was in the 180's while Japanese expansion will slow somewhat from its recent fast rate. Other Pacific Basin countries may also fall off from their prior torrid rate of growth but still be well above average. World competition will intensify further, and there is some risk of a splintering into trading blocks. We suspect that relative stock price behavior will become more erratic but that essential market leadership will shift from the long supreme consumer group to the industrial, capital goods, technology and energy sectors which have lagged so since 180. We also think that the small capitalization universe may enjoy a few years of relative price superiority after a long stretch of underperformance. In the retirement fund area, the public funds will probably sustain their recent superior growth momentum over corporate pension money where advances will continue to be inhibited by the increasing implementation of defined contribution programs such as 401-Ks and profit sharing plans. The trend toward indexation may slow except in regard to bonds and foreign investing, but the substitution of tilt funds may accelerate at the expense of the plain vanilla index funds. We expect global investing to grow rapidly, partly because it still is at such a low base, but we doubt that real estate will be an especially dynamic area over the next two or three decades. XI. The Meaning What are the implications of some of these trends? First, there will be an effective downward pressure on management fees and continuing pressure on brokerage commissions. Some of the excessive capacity in the brokerage business will be sliced off, but this means a reduction in sell-side research and a tailoring of the brokerage product so that all clients will not receive the same product and service. The trend toward unbundling will continue, and the lines of division between brokers and clients will continue to blur as they come into competition with one another more frequently. Unfortunately, this also means that the relationship becomes more adversarial. We hope that it stops before nothing but dealer markets remain, because we don't think, that anyone would benefit from that. The public, in turn, will not soon revert to direct ownership of equities and will increasingly rely on mutual funds unless the Congress succeeds in implementing an end to the double taxation of dividends. Some generalizations we might draw are that the mutual fund companies -- especially those with a strong distribution and marketing capabilities and multi-funds -- will continue to grow. We suspect that, while boutiques were the rage in the 10's, they won't be in the decade ahead, particularly the single-product shops, unless they record superior performance results or have an unusual niche. The big, multi-products firms that are well managed are positioned to prosper since they have the capital to make the required investments in the new technologies and quantitative techniques. An increased pace of consolidation is likely -- particularly in the form of linkages with foreign investment management firms -- as everyone struggles to enhance their global investment capabilities.XII. An Invitation The advantages that well capitalized and multi-product companies may possess in the investment world of the next decade will fade unless those companies are focused and good at what they do. The major casualties in the scant 0 years the investment business has been in flower have been some of the banks and insurance companies, but most of the weak competitors have been flushed out, and most of those that remain have demonstrated skills that have facilitated their survival and, in a number of cases, strong growth. In fact, performance measurements show many banks achieving well above-average results over 10-, 5- and -year time periods. A number have established superior and even dominant positions in areas involving indexation, quantitative techniques, the sale of hard dollar research and the servicing of high net worth individual investors. Most of the success stories have come from the ranks of insurance companies and banks that have given a separate identity to their investment operations by spinning them off as subsidiaries, establishing them as boutiques and, in some cases, divesting them and retaining only partial interests. There have been instances, too, of massive reforms where formerly large and powerful investment divisions of huge institutions have restructured and essentially reestablished themselves as top-ranked competitors.XIII. What Makes for a Poor Firm? In summing up this brief discussion of the investment management business, we could conclude that the best days of the business are behind, but there will be plenty of good ones ahead. And we cannot think of a business that is more challenging, dynamic and exciting in which to be involved. The decade ahead promises more in the way of incredible change. Rather than listing again the attributes of a superior organization, we might conclude with a description of a badly run firm. It would be one at which • Investment management is a peripheral part of the total operation, • Final decisions are made by non-investment or marketing people, • The management structure would most likely be hierarchical, • Most important investment decisions are made by committee, • There is no clear vision of what the organization is trying to accomplish; goals have not been articulated and communicated effectively to clients and employees so that everyone knows exactly what it is about, • Priorities are twisted so that the company has become oriented inward and has forgotten that it is a service business wherein the client comes first, • The use of disciplines in decision making is lacking, • Managers have failed to attract and retain top-flight people because the climate is not creative, and there is not a pattern of teamwork, • Compensation is not competitive, and inequities have been allowed to build in its compensation and reward systems, • The egos of those who, unfettered, can be destructive, have not been managed properly, • Mediocrity and deadwood have too long been tolerated. To the outside observer, such a firm probably appears as an organization without direction, blowing in the wind, riding with the fads and fashions, which has failed to establish itself as a superior group of professionals. For such a company, there is only the dustbin because the competitive skills of so many others continue to improve.Originally issued as a Donaldson, Lufkin & Jenrette Strategy Commentary on Jan. 6 and Feb. , 10 and written by Eric Miller, Sr. Vice President.
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