Evaluating Investment Skill: Important Lessons

Evaluating Investment Skill: Important Lessons

Several years ago, even as the bursting of the dot-com bubble was well underway, an article posted on one of the Internet stock market commentary sites offered important lessons in how difficult it can be to evaluate investment skill. The subject was the Sequoia Fund, an investment outfit run by very disciplined and competent people who had produced enviable results for their limited number of investors (the fund was closed to newcomers in 1982) over their 30-year history of operations. Its investment approach was, in a way, limited, too: it invested in a small number of securities which it held ?forever.?

It was just such characteristics - low turnover, long holding periods - that came under fire in the article for being 'stodgy,? 'stagnant? and ?frozen.? These qualities, the author implied, accounted for the fund's poor results: Sequoia ?has underperformed the S&P500 for ten years,? capped by an especially poor year in 1999 when it returned -16.5% versus a 21% gain for the S&P. Yet, the commentary continued, some recent transactions offered a ?breath of fresh air? to shareholders who ?have seen better days? due to a strategy that was out of date ?in a changing stock market.? Curious, we decided to investigate.

A quick perusal of Sequoia's numbers since 1990 was intriguing: the fund's results were, in fact, superior to those of the S&P every year save three, and only the large gap in 1999 brought its cumulative returns down to a below-S&P level, after having been substantially ahead of that index for the entire decade (at the end of 1998, for example, Sequoia's annualized results over the period were 21.2% vs 17.9% for the S&P). Furthermore, Sequoia's returns for the entire stretch since inception in 1970 were 17.3%, annualized, compared to the S&P's 14.6% over the same period ? not too shabby. Shareholders were not likely to have been very upset about a single year that probably didn't mean too much in the overall scheme of things.

The unsophisticated and shallow analysis of the Sequoia Fund we have cited illustrated very well the image problems which investment operations like Sequoia had in a speculative market fascinated with a favored sector (technology) to the exclusion of others, and not prone to critical thinking. It also made clear the difficulty of appraising the merits of and choosing competent advisors. Shallow analysis abounds in the financial world, and results like Sequoia's made for an easy target: in 1999, they trailed the S&P index by nearly 38%, setting back the fund's cumulative returns relative to the market index over a long period of years. Nevertheless, a more thorough examination in such cases could prove revealing ? and profitable -- to those seeking to evaluate different investment approaches. Let's continue with our look at Sequoia.

Past performance is no guarantee of future results, as they say, and one need look no further than Sequoia's own record to find proof of this statement. 1999 was not Sequoia's first poor year. Astoundingly (when viewed in light of its long-term record), the fund trailed the S&P during each of the first four years of its existence (excluding a partial year in 1970 when it also lagged the market index). At the end of 1974, Sequoia's cumulative returns stood at negative 15.5%, compared to the S&P's modest gain of 2.8% (1973 and 1974 were bad years for owners of equities). The author of the article we have been discussing, had she been observing the fund's results at that time, would undoubtedly have concluded that something was dreadfully wrong at Sequoia.

Subsequently, the fund's performance was subpar for two consecutive years in 1979 and 1980, and again in 1985 and 1986. It also experienced relatively poor results for each of the three years 1988-1990. During all of these periods, one could have asked the same question that is being asked now: is the fund's 'stodgy long-term buy-and-hold strategy? obsolete ? out of step with today's marketplace? Historically, at least, the answer had always been no, and returns in subsequent periods more than made up for the lagging years. But since past results are no guarantee of the future, what was the outlook for Sequoia in 2000? Had things really changed that much?

This is a judgment call that goes to the heart of all investment decision-making. At the time, we felt the prospects for funds like Sequoia remained positive. The strength of its long-term results demonstrated the foolhardiness of simply dismissing a proven investment approach because of one year (or even two or three) of below-market returns. The fact that this strength was due not to a brief period of extraordinary gains in the past (indicating a flash-in-the-pan phenomenon), but was spread out over its history, was also encouraging. As for the unusual lag in 1999: that year's market returns, as measured by the major indexes, were distorted by a heavy concentration of buying in very few stocks ? stocks of a type with which the fund would typically not get involved. These distortions masked a general decline in the values of most stocks. Sequoia's results in this environment were not surprising or worrisome, nor were they, in isolation, conclusive when judging the competence of management or the long-term viability of their methodology.

Also significant was the presence of a stable policy that made economic sense. Owners of businesses have accumulated great wealth in our society and Sequoia's buy and hold practice took advantage of the economic factor that creates this wealth: good businesses tend to increase in value over time. On the other hand, the more active approach advocated by the Internet article was less viable, economically, since it increases costs (more transaction fees and taxes), while offering no evidence that long term results will be better. The fund's relatively low fee structure (1% of assets) was also to the investor's advantage. Finally, there was the issue of risk. A fund such as Sequoia, which holds long term positions in well-entrenched enterprises, would surely be considered less risky than one which follows the latest market fads, which is what is usually signified by the phrase ?changing stock market.?

Sequoia's results subsequent to 1999 (9.3% annualized against -1.1% for the S&P) indicate that our evaluation of the fund at it's most recent low point was sound. Importantly, this experience illustrates the importance of two key factors that need to be considered when evaluating investment operations: avoiding fads and looking beyond short-term numbers. Unfortunately, it also points out the difficulty of a third factor'the necessity to delve into an investment firm's methodology and personnel to determine whether what they are doing makes economic and investment sense and that they are acting in a disciplined, consistent manner. Admittedly, this is a challenging undertaking for the average investor, but unavoidable if one hopes to achieve satisfactory long-term results with investment advisors.