Prudence in Volatile Times - A Case Study
Prudence can seem very imprudent in a runaway bull market. In fact, it can seem downright stupid.
Jean-Marie Eveillard’s career provides a delightful insight into this irony – both the downside of exercising prudence when share prices are soaring; and the satisfaction of exercising prudence long enough to prove its value. Eveillard knows this reality firsthand.
“A good value manager accepts that there will be periods of short-term pain,” Eveillard once said. “It is one reason that there are so few good value managers. It’s not just psychological. You may lose clients, or even your job.”
During Eveillard’s first decade at the helm of the First Eagle Global Fund (originally called the Sogen International Fund), it easily outdistanced every applicable benchmark. From the fund’s inception in November 1986 through March 31, 1997, First Eagle Global Fund delivered a total return of 236%, compared to only 133% for the MSCI World Index.
This dazzling performance elevated Eveillard to celebrity status – so much so that he became a little nervous about the stock market…and increasingly cautions. He was also concerned that so many flimsy tech stocks were soaring for no good reason, and that compelling values were becoming almost impossible to find.
Eveillard responded to these conditions by raising the cash level in his fund and also raising his exposure to gold. As a result of Eveillard’s caution, his fund lagged far behind every relevant benchmark during the next three years. Between March of 1997 and March of 2000, First Eagle posted a total return of only 28% – or barely one third the 75% total return of the MSCI World Index. Eveillard’s numbers seemed even more pathetic alongside a tripling of the NASDAQ Composite Index during the same timeframe!
Eveillard was unflappable. He refused to embrace the tech stock mania that was powering financial markets around the globe to new highs. Instead, he simply maintained the value-based investment process that he had always pursued. In his self-defense, Eveillard simply stated, “I would rather lose half of our shareholders than half of our shareholders’ money.”
And that’s exactly what happened. As Eveillard later confirmed, “We did lose half our shareholders; we did not lose half our shareholders’ money.” For three long years, it looked like Eveillard’s illustrious career might end in disgrace. His fund nearly closed down. But as it turned out, Eveillard’s prudence was, in fact, prudent. In the ten years from March 31, 2000 to March 31, 2010, the S&P 500 Index and the MSCI EAFE Index both produced a negative total return. Over the identical timeframe, the First Eagle Global Fund more than tripled!
Seth Klarman, another outstanding investor who has been prone to producing mediocre short-term results, shares Eveillard’s outlook. In Klarman’s 2004 client letter, he wrote: “By holding expensive securities with low prospective returns, people choose to risk actual loss. We prefer the risk of lost opportunity to that of lost capital. With our efforts focused on minimizing permanent impairment of capital, we also do not promise to make you the most amount of money in any short period of time. You have seen that in our results.”
Klarman expanded upon this theme in his book, “Margin of Safety,” when he observed, “Like dogs chasing their own tails, most institutional investors have become locked into a short-term, relative performance derby. Who is to blame for this short-term investment focus? Is it the fault of managers who believe clients want good short-term performance regardless of the level of risk or the impossibility of the task? Or is it the fault of clients who, in fact, do switch money managers with some frequency? There is ample blame for both to share.
“There are no winners in the short-term performance derby,” Klarman continued. “Attempting to outperform the market in the short-run is futile since near-term stock and bond price fluctuations are random and because an extraordinary amount of energy and talent is already being applied to that objective. The effort only distracts the money manager from finding and acting on sound long-term opportunities. As a result, clients experience mediocre performance. Only brokers benefit from this high level of short-term think.”
By eschewing the conventional pursuit of superior short-term returns, Klarman has amassed an enviable record of superior long-term returns. From its inception in 1983 through Dec. 31,2009, his Baupost Limited Partnership Class A fund has earned an average annual return of 16.5%, net of fees, compared to 10.1% for the S&P 500. During the “lost decade” of 1998 to 2008, Baupost’s fund crushed the S&P, returning 15.9% for the period vs. a loss of 1.4% for the S&P.
Prudence sometimes seems imprudent. But it never is.