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If investing can be compared to farming, then selecting stocks is analogous to choosing cows. When an investment fails to perform as expected, the question becomes, “Who spreads the manure?”
My schoolmate “Scott” runs a serious amount of money as an investment professional; his AUM are multiple orders of magnitude greater than the single-digit millions that we have in our family office. In addition to being a kind and thoughtful husband and father and a very capable investor of other people’s money, Scott is also a wickedly funny guy.
As we come up to this summer’s 60th reunion for our class of 1962, our chats and calls become more and more weighted down with gallows humor. Our most recent conversation was about the previous article I had written for Advisor Perspectives about our family office’s investing methodology. After I finished explaining how our family office members thought of ourselves as investment farmers, he reminded me that, in addition to having gone to the same secondary school, we also shared the experience of each having spent a summer in Vermont in the late 1950s working on a dairy farm. Then he asked a question.
“So,” he said, “you use a magic formula to decide how many Holsteins, Jerseys, and Guernseys to own. Who does the manure spreading?”
None of the Midwestern farms whose business histories our family office tries to emulate spent any time in the dairy business. They grew forage, corn, barley and then soybeans. But, I told Scott, if our family office farm were a dairy, we would be the buyers of the less commonly owned breeds: Brown Swiss, Ayrshire, and Milking Shorthorns. Our portfolio is off in its own small corner; what we own hardly matches the overall market. Measured by Google Finance, the 14 stocks we own are rated as 69% small companies, 31% medium dividend investments, and 38% medium P/E investments. The market capitalization of our biggest company’s common stock is less than $5 billion.
As relative amateurs, answerable only to ourselves, our family office measure only our quarterly and annual rates of return. We have that luxury because we only have responsibility to each other and none of us has any faith in our ability to predict the business cycle. Scott is not such a financial agnostic about the future. As he says, with a smile, very few professionals can afford to be without faith. Even the indexers must presume that the trend will be their friend. We in the advisory business, Scott has told me, all think the way people who lived in Boston did in the good old days when everyone was a Congregationalist. (My friend knows his own family’s Pilgrim history.) We are against gambling, and at the same time we have faith in our ability to handicap the future.
“If your family office members do not think they can outperform the market, then why do you choose particular investments at all? If you don’t think you can do better than chance about timing, shouldn’t you also be committed to indexing? How, logically, can you decide what and when to buy if your family office thinks that investment guesses do not have better odds than chance?”
Our answer is that we think prices are relentlessly random because their purpose is to mediate each moment between the bids and asks of buyers and sellers and the expectations of the owners of stock who are watching what the buyers and sellers are doing. Prices are people’s instant opinions about fashion, the weather, and the millions of other considerations that affect the inventory, supply and demand for whatever is being traded. That is why Eugene Fama can be a permanent skeptic about whether “bubbles” can be predicted.
Where we think investors can find faith in expectations is in the examination of the numbers that count what companies do. We believe that accounting can do much better than chance at finding quality. The development of land grant colleges in the 19th century was driven by the belief that quantitative measures could be developed to judge quality. If science could not predict crop prices, it could reduce the risks of crop failure.
The quality of private companies, like that of farmland and equipment, can be measured by their records of past performance. Like agronomists, accounting scholars have shown considerable ability to create metrics that do better than chance at estimating future performance. To measure a company’s quality, we use the academic scoring methods developed by Altman, Beniesh, Piotroski and Sloan. Those yardsticks are incapable of predicting the market prices for what our family office farm owns; but they can reduce our risks of loss from fraud and management stupidity.
Stefan Jovanovich manages the portfolio for his family office that farms common stocks and Treasury notes in Nevada.
