Chairman's Letter - February 2009
"There is no education like adversity," Benjamin Disraeli, the late British prime minister, observed.
If he’s correct, then we in the investment-management business are now earning our PhDs. We are dealing with the biggest economic calamity of several generations, which in turn has led to the second-worst stock market collapse in history.
There is little need to rehash all the details of this train wreck of an economy and this grizzly bear of a stock market. To us, the most important thing, in the spirit of Disraeli’s observation, is, what has this adversity taught us -- especially in helping us do a better job for our clients going forward? I’ve been thinking about that question a lot lately, in terms of our firm’s growth-investment philosophy, growth-investment disciplines, and Growth Investing Team and in terms of the future course of the stock market. And during this atypically harsh time for the economy and the market, I want to share some of these thoughts with you.
On our growth-investment philosophy
It seems like only yesterday: in the early 1980s I conceived a growth-investment philosophy based on a simple premise: the best investment philosophy is one that plays to the strength of the stock market. Namely, if the market has gone up more than 70% of all years historically and has few consecutive down years, then it makes sense for an investor to do two things: 1) stay fully invested and 2) buy stocks of companies that are increasing their earnings.
We refined that philosophy when we started this firm in 1990 by keeping our diversified stock portfolios "sector-neutral" (keeping the portfolio weightings in each market sector comparable to those of the target indexes) so as to focus on what we can control -- picking good stocks -- and not waste time on what we can’t control -- anticipating which sector will perform best at a given time.
For nearly 20 years that growth-investment philosophy has proven effective. It enabled this fledgling of an investment firm to fly and earn a good performance record in its first decade of existence. That led to solid growth for the firm and many satisfying long-term client relationships.
Then came the decade of the Terrible 2000s, which has subjected our growth-investment philosophy to considerable stress. The 2000s inflicted two of the four worst bear markets ever; as a result, for the nine years of the decade through December 31, 2008, the S&P 500 Index is down an annualized 3.60% and the growth-investing style, as represented by the Russell 1000 Growth Index, has lost even more, an annualized 7.72%.
In short, the 2000s are shaping up as the worst decade for stock investing since equity performance first began to be extensively documented in the 1920s. In such an unpromising investing environment, it’s paid to hold sizable cash positions in a portfolio. And it’s been better to own shares that are cheap (value stocks) than shares of companies that are increasing their earnings (growth stocks). Even so, we have stuck -- and will continue to stick -- to our investment philosophy emphasizing earnings growth, which has been, is now, and in our view will remain the essence of both the stock market and capitalism. Quite simply, over the long haul the stocks of companies with good earnings go up and the stocks of companies with poor earnings go down.
As we see it, the probability is high that our investment philosophy will lead to better investment results soon. Over the next several years we believe stock prices in aggregate should rise and in the process equal or exceed the long term average of 10.4%. According to Charles Schwab, when the stock market’s annualized total return for a 10-year period fell to 1% or less, the next 10 years produced an average cumulative return of 175% -- 10.4% a year. And we think the stocks rising the most are likely to be those of companies generating the best earnings.
As we never tire of repeating, the success of investment managers over time hinges on their adhering to their investment philosophy and disciplines, especially when the philosophy and disciplines are being tried the most. Indeed, it’s a sad irony of the money-management business that the temptation to deviate from one’s investment disciplines often tends to be strongest at precisely the wrong time, just when that process is about to return to favor. Clients have told us that one key reason why they have kept faith in us over the years is that they believe in what we are doing because we believe in what we are doing. We have the courage of our convictions and no tolerance for "style drift."
To be sure, the value style of investing can outperform the market for long periods of time, as can the growth style. But when value or growth managers tend to get into trouble is when they drift during market extremes out of expediency or desperation, in an effort to turn around their performance. As we see it, the currently out-of-favor growth style is likely to outperform for an extended period soon, and we believe we will be among the leaders of the pack when that happens.
On our growth-investment disciplines
Our growth-investment disciplines boil down to buying stocks that meet three criteria: their earnings should exceed Wall Street’s expectations, based on our fundamental analysis; they rank highly in our proprietary quantitative model; and their technical trends, such as their trading volumes and pricing patterns, are attractive. Conversely, we look to sell stocks that violate those criteria.
In its fundamental analysis, our Growth Investing Team continues to do an admirable job of identifying those stocks for which earnings exceed expectations. However, when the global economy and market are collapsing, as is the case now, the stocks with the most earnings growth typically go down the most. Just consider two bona fide growth stocks, Apple and Google. Each company has reported above-average earnings over the past 15 months (including the most recent quarter), but each has had its price/earnings multiple cut in half, in concert with a significantly smaller reduction in the overall market’s multiple.
And our quantitative model has worked supremely well. The dilemma for us as growth investors is that the model isn’t oriented exclusively to growth stocks; it simply ranks all stocks, both growth and value stocks, on many factors that in our view are predictive of future investment outperformance. At this time, the model’s factors are favoring value. So our predicament can be summarized in this way: although we use the model as a guide, we still need to buy growth stocks to stay true to our investment disciplines, and that has detracted from our performance over the past year.
And as for technical analysis, the third (and most modest) element of our investment process, it’s proven useful to us in adapting to a wildly volatile stock market. In the last four months of 2008, for instance, the S&P 500 Index suffered four of the 20 biggest daily percentage declines in its history. And of the 253 trading days in all of 2008, the S&P 500 fell more than 3% on 23 of those days, or 9% of the time.
We think our investment disciplines, like our investment philosophy, should work well over time -- our Growth Investing Team routinely identifies the stocks with the best earnings dynamics, our quant model is good at ranking stocks likely to outperform, and our technical analysis helps us to fine-tune our investment decisions. When the market at long last resumes its upward bias and when stocks with the strongest earnings rebound (both of which we believe will happen), we are confident our disciplines are likely to once again deliver excess returns to you. We think the rebound of growth stocks may be especially robust in light of how their valuations have been so beaten down over the past 15 months, heightening their return potential.
On our Growth Investing Team
We are privileged to have a Growth Investing Team of top-notch portfolio managers and security analysts who become equity owners, enjoy managing money and doing sector research, and savor belonging to a cohesive team. So they stay with us.
As you may know, the Growth Investing Team is organized into five analyst teams that cover the market sectors -- the consumer, cyclical, financial-services, health-care, and technology/telecommunications sectors. Our senior portfolio managers/security analysts who lead the sector teams have been with us 15 years on average. The second and third members of the sector teams have been here an average of seven years.
We think what’s most noteworthy about the Growth Investing Team is that it is a team; the team members collectively are responsible for making investment decisions, not a single superstar who can leave, draw a cold hand, or burn out. We think the continuity and stability of our team increases the likelihood that our investment results will only get better over time. Indeed, portfolio managers, like harness-racing drivers, seem to get better with age. As I’ve noted before, investing whizzes like John Templeton, Warren Buffett, and Bill Ruane were only hitting their stride in their 40s and 50s.
Moreover, we firmly believe a good team is an ethical team that does the right thing. That’s why our portfolios have always been subject to asset-capacity limits; we close our portfolios once they reach a certain predetermined size to preserve their return potential, so that we can continue to do our best for you. And that’s why we prohibit our portfolio managers from actively trading in their own personal stock portfolios; we want our portfolio managers to invest in the mutual funds they run instead. We can think of no better way of ensuring that their interests are closely aligned with your interests as a client. In Turner’s Wide World of Investing, they share with you the thrill of victory (gains) and the agony of defeat (losses). Finally, we seek to treat all of our employees well: 75% of our employees are principals, with equity ownership in the firm. Each employee contributes to the firm’s success -- to putting you, the client, first -- in his or her own unique way and is rewarded accordingly.
On the lessons learned
So what have we learned from adversity?
First, we’ve learned that the macroeconomic events of the 2000s have trumped individual stock events. The members of our Growth Investing Team, in performing their bottom-up security analysis, are keenly aware of the macro influences affecting their sectors. And the longer they do their jobs, the greater the knowledge they acquire of those macro influences.
Our Growth Investing Team now formally examines and discusses such macroeconomic events at its longstanding Thursday afternoon investment meetings. And on an informal basis, the same sort of examination and discussion occurs almost daily as the team goes about its work in our Investment Center. Also, the senior members of the team meet regularly to dissect the current and prospective impact of macroeconomic events on the market.
A second lesson we’ve learned is the need to incorporate into our quantitative model more third- and fourth-standard deviation events -- events that may seem highly unlikely but that have the potential to hurt stocks badly when they do occur. One recent example of a third-standard deviation event: first-rate health-care companies like Intuitive Surgical have been stymied by customers’ inability to obtain credit and buy their products, thereby helping to negate demand for those products.
During the bear market of 2000-2002 we tightened the risk controls in our model, which contributed to our investment performance over the following five years. Similarly, we’ve placed greater emphasis in our model -- and in our fundamental analysis -- on treating future macro events as another form of risk control, and we think our performance will be the better for it in the years ahead.
On the stock market
Finally, about the prospects of the stock market, I’m reminded of an experience 15 years ago, when I attended a Philadelphia Eagles football game on a Monday night.
Seated in front of me at the game were three motorcycle-club members, their club’s logo emblazoned on the back of their jackets. They were big, loud, and drinking heavily. Seated beside them was a young man whose laid-back manner suggested a California surfer who had some familiarity with the recreational uses of marijuana. No fool he: his attitude toward the three motorcycle guys was utterly respectful and deferential. At the end of the third quarter, the three motorcyclists vacated their seats temporarily, presumably to take a bathroom break and buy more beers before last call.
While they were gone, two preppie-looking guys who appeared to be of college age descended from an upper section of the stadium to claim what seemed unoccupied seats. The surfer sized up the situation, looked at the two preppie interlopers, and said in a deadpan tone, "Dudes, you’re about to make the worst mistake of your lives." The preppies initially looked at him with puzzled expressions, but they got up and left, perhaps motivated by some divinely sent forebodings of trouble and bodily harm.
The motorcycle-club members did indeed return to their seats shortly thereafter, unaware that, to everyone’s great relief, an affront to their fraternal honor had been averted, an affront that almost certainly would have inspired a bruising retaliatory response on their part.
So in closing, I offer the following advice to those of you who may be thinking of bailing out of the stock market or giving up on a growth-stock manager like us: "Dudes, you’re about to make the worst mistake of your lives."
As we see it, it would be an enormous error to forsake the stock market or us now. By just about any criteria you choose -- whether it be valuation, investor sentiment, technical readings, past patterns of performance, you name it -- stocks look as compelling as they’ve ever been in modern times, in our view. Stock characteristics, aggressive federal monetary and fiscal policies, an economic-stimulus package of more than $800 billion, the principle of reversion to the mean (the tendency for below-average investment returns to adjust, or revert, to the long-term average), our sound investment philosophy, and our time-tested growth-investment disciplines -- all should conspire to produce good results in stocks over the next few years.
To be sure, there may be disappointments and setbacks in the short term, but we think the U.S. market will ultimately lead other nations’ markets higher and furnish great buying opportunities in classic growth stocks like Google, Apple, Gilead Sciences, Monsanto, and Qualcomm. We also think that early-cycle stocks -- stocks in industries such as retailing, home construction, finance, and semiconductors that tend to do well historically when the economy starts to recover or even just declines less than before -- can double or triple in price.
Finally, we thank you for your patience, for continuing to keep faith with us through the fat and lean years of investment performance. You have certainly endured a lean year in 2008. Now we think fat years lie ahead. If you stay the course, we are confident that we can indeed produce superior long-term results for you (and for us, since we eat our own investment cooking).
Past performance is not a guarantee of future results. The views expressed represent the opinions of Turner Investment Partners and are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities.
Turner Investment Partners, founded in 1990 and based in Berwyn, Pennsylvania, is an investment firm that manages more than $15 billion in stocks in separately managed accounts and mutual funds for institutions and individuals, as of December 31, 2008.
As of January 31, 2009, Turner held in client accounts 984,282 shares of Google, 2.3 million shares of Apple, 6.2 million shares of Gilead Sciences, 2.4 million shares of Monsanto, and 8.2 million shares of Qualcomm.