From the Archives: Value Trap: Eastman Kodak

January 19, 2012

Bill Miller at Legg Mason Value Trust had one of the longest mutual fund outperformance streaks in history, 15 years through 2005.  His record may end up like Joe DiMaggio’s longstanding consecutive game hits record—never equalled and rarely even approached.  Yet even superstar fund managers may occasionally have feet of clay.  According to a Bloomberg article, his fund has had a rough time with Eastman Kodak:

Legg Mason Capital Management Value Trust (LMVTX), run by Miller since 1982, disclosed in a semi-annual report last week that the fund sold 18.2 million Kodak shares late last year and during this year’s first quarter for about $3.89 each on average. The fund realized a $551 million loss through the divestiture, according to the report.

Miller, 61, began loading up on Kodak shares in 2000 and, by the end of 2005, his firm owned as much as 25 percent of the Rochester, New York, company. Value Trust, one of several Legg Mason funds and accounts to hold Kodak stock, kept the bulk of its stake for more than a decade, only to sell after the film company had lost more than 90 percent of its market value.

Someone took the Kodachrome away


One of the challenges that value investors must take on is the value trap.  A value trap is a stock that looks cheap, but turns out to be cheap for a reason.  EK didn’t necessarily hold Bill Miller back; he had quite a number of years of market outperformance with Kodak included in the portfolio.  Other selections did pan out and more than offset the problem stocks.  The problem with value traps is psychological.  The Bloomberg article goes on:

“Part of it was just this mentality that this was just a temporary setback and Kodak would be able to get quickly back on track,” said Bridget Hughes, an analyst at Morningstar Inc., a Chicago-based stock and fund research firm. “It was not only a mistake, it was also causing a lot of client angst.”

I put the psychological problem in bold.  It drives clients crazy to see a big loser in the portfolio quarter after quarter, year after year. Even when buying cheap stocks is obviously part of the investment philosophy and when patience is required to get good returns, clients sometimes struggle with it.

Portfolio management using a systematic relative strength process has different strengths and weaknesses.  Clients are less likely to see a big loser sitting in the portfolio quarter after quarter, but are more likely to see more numerous transactions that result in small or moderate losses.   I suspect clients are no happier about a string of small losses, but they often seem to be able to let it go.  On the plus side, when using relative strength, most of the big winners will be retained in the portfolio for an extended time.

No investment approach is perfect, and every investment methodology will have its fair share of mistakes.  Still, clients choose to stick with some investment managers and bail on others, even when their long-run performance is comparable.  The client’s choice is often made primarily on the basis of emotion—sometimes just how they feel about how things are going.  All other things being equal, why would you elect to have your big losers show up on client statements for an extended period of time?


—-this article was originally published 6/30/2011.  Today EK filed for bankruptcy.  Someone finally took their Kodachrome away.  Kodak has had persistently poor relative strength for years.  Relative strength has its issues, but getting stuck in value traps is not one of them!

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Your Inner Beardstown Lady

January 19, 2012

Most of the whippersnappers in the business don’t even remember the Beardstown Ladies.  They were grandmotherly-looking members of an investment club in Beardstown, Illinois who had generated 23% returns on the investment pool for many years.  According to an 1998 story in the Wall Street Journal:

The Beardstown Ladies are members of a famous investment club formed in the early 1980s. The ladies rose to prominence in the mid-1990s after the club proclaimed fantastic investment results. For 10-years ending 1993, the club reported a compounded return of 23.4% in their stock portfolio versus 14.9% for the S&P 500. The ladies bought stocks of companies they knew, like McDonald’s and Coke. The investment success propelled the ladies into stardom. They appeared on TV shows and in commercials, spoke on radio programs, and not to miss a moneymaking opportunity, published best selling books on the subject of personal finance and investing. The world changed for the Beardstown ladies in late 1997. A reporter from the Chicago magazine noticed something peculiar about their published investment results. After calculating the numbers several times, he concluded that a gross error had been made. The error was so large, that the accounting firm of Price Waterhouse was called in to clear the air. In the final tally, the clubs worst fears were realized. The ladies’ actual return was only 9.1%, far below the 23.4% they reported, and well below the S&P 500. For years the ladies deposited monthly dues into their account and classified it as an investment gain, rather than additional capital. An embarrassed treasurer blamed the error on her misunderstanding of the computer software the club was using.

Unfortunately it’s not just the Beardstown Ladies who can’t do math.  No one questioned the returns initially because they wanted to believe it was true.  The exact same error is repeated by most 401k investors who often count their contributions as part of their performance.  Even in the absence of contributions, the rest of us favorably mis-remember our results anyway.  Psychology Today explains:

What was your portfolio return last calendar year? How did you perform relative to market indexes and other investors? Most investors don’t know the answers to these questions. But their belief in their performance is quite flattering to themselves!

Two interesting studies illustrate this point. In the first study, William Goetzmann and Nadav Peles surveyed a group of investors belonging to the American Association of Individual Investors (AAII) and a group of architects about their retirement plan investment returns. The AAII investors are presumably very knowledgeable about investing from their participation in the association. When asked about their return the previous year, they overestimated their performance by 3.4% (= estimate – actual). Architects are very intelligent with a high degree of education, though they may not be knowledgeable investors. They overestimated their return by 8.6%. Both groups were also asked about their performance relative to a benchmark made up of the same asset allocation. The groups overestimated their relative performance by 5.1% and 4.2%, respectively.

Markus Glaser and Marin Weber also conclude that investors have biased views of their portfolio performance in the past. They surveyed individual investors from a German online brokerage firm and compared their self-assessments to their actual returns over four years. They reported a belief of an annual return mean of 14.9% over the period. Their actual return was more like 3.3%. Now that is overconfidence! In fact, there was no correlation between the actual return and the beliefs about the returns in the sample.

Cognitive dissonance strikes again.  According to Goetzmann and Peles in the Psychology Today article:

The authors attribute this to a psychological phenomenon called cognitive dissonance. The investors are mentally distressed by the conflict between a good self-image and empirical evidence of poor choices. To reduce the discomfort, investors adjust their memory about that evidence and those choices. This is then selectively re-enforced by noticing the returns of just their good performing stocks and mutual funds in the portfolio and not the poor ones.

Self-image wins every time.  A keen observer will note that investors never vastly underestimate their aggregate returns!

What can we learn from this, other than Germans are the most confident investors on the planet?  I’ve bolded the return estimates, just so you can see clearly how large the gap in perception created by cognitive dissonance really is.  The bottom line is that we all want to imagine we are getting or can get fantastic returns.

Right now we are smack in the middle of crazy season, where investors are examining their prior year returns and determining whether to stay with their current mutual fund or investment manager.  As an investment professional, one of the things you quickly realize is that you are being compared with imaginary numbers–what the client believes you should have done, or what they imagine they would have done!  Of course, as discussed above, the imaginary numbers are always terrific.

Cognitive dissonance, I believe, accounts for a lot of the manager turnover in the industry, not just volatility and style rotation.  As evidence, consider that according to DALBAR, the average holding period for mutual fund investors is about three years–whether they own a stock fund or a bond fund.  The volatility of the average bond fund is probably not enough to shake investors out, but when comparing the bond manager’s actual returns with imaginary returns, investors can only handle three consecutive years of disappointment!  Ok, I’m being a little sarcastic here, but this corresponds perfectly with studies of black-box trading systems, which indicate that investors who purchase even a profitable system abandon it after three consecutive losses.  (For fans of Markov probability chains, an average of only fourteen coin flips is required to get three heads in a row.)

When it comes to returns, we are all Beardstown Ladies at heart.  Our imagined returns are always going to be significantly higher than what we actually get.  Keep in mind that, according to the Psychology Today article, there was no correlation between the actual return and the beliefs about the returns.  Instead of being bamboozled by your inner Beardstown Lady, step back and really think about your investments.  Do they meet your needs?  Is the underlying return factor still sound?  Keep in mind that the only investment acumen required to actually earn the mutual fund NAV returns is to hold the fund!  You don’t have to condemn yourself to DALBAR-type returns.  Sure, if something has gone really wrong, you might need to make a gradual change in course–but more often than not, if the return over a multi-year period is in the ballpark, you’re quite possibly better off leaving it alone.  If you want to be a successful investor, you need to learn to deal with the real world and not imaginary returns.

Reject your inner Beardstown Lady!


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From the Archives: Punting When the Chips Are Down

January 19, 2012

Sunday night’s football game between the Patriots and the Colts was one for the ages.  Two future Hall of Fame quarterbacks on the two winningest teams in recent years faced off.  Ultimately the game turned on a decision that had to be made by the Patriots’ coach, Bill Belichick.  The Patriots had a fourth down with two yards to go deep in their own territory.  If they succeeded in getting it, they could run out the clock and win the game.  If they failed, the Colts would have the ball and enough time to score.

A statistician cited in the Wall Street Journal article about the play points out that the numbers are clear.  The Patriots had a 79% of winning the game by going for it on fourth down, either by converting or by stopping the Colts from scoring afterwards, but only a 70% chance of winning if they had to stop the Colts from driving down the field after a punt.  The Patriots, going with the numbers, elected to go for it, failed, and ended up losing the game.

The most interesting thing about the decision was not that the Patriots went with the odds and ended up with the short end of the stick.  The interesting thing is how vocal fans and the sports press have been about Mr. Belichick’s “bad” decision.

The kind of thing comes about because people have a tendency, in matters of probability, to confuse decisions and outcomes.  The Patriots indeed had a bad outcome, but the decision seems to have been statistically correct.  The reason that people are responding to the decision so harshly has to do with the cognitive bias of regret avoidance.  The Wall Street Journal article points this out very nicely:

In a recent study, researchers from Duke and UCLA found that when faced with a decision involving risk, people have an overwhelming tendency to make the supposedly safe choice—to err on the side of caution—even though doing so may lead to worse results.By studying thousands of hands of blackjack played by random people, the researchers found that when they strayed from the “book” or the optimal strategy, those players who did something aggressive were more successful than those who did something passive.

In fact, the subjects made four times as many passive mistakes as they did aggressive ones. And these passive mistakes—holding on a 16 when the dealer has a king showing, for example—were more costly: They cost $2 for every $1 won, versus $1.50 for every $1 won on aggressive mistakes.

Why do people embrace caution? “It’s because of the regret that people face when they take an action and it doesn’t turn out well for them,” says Bruce Carlin of UCLA’s Anderson School of Management, who worked on the study.

Think about that for a few minutes: people made four times as many passive mistakes as they did aggressive ones.  And the passive mistakes were more expensive.  Maybe risk aversion is not such a good idea in certain circumstances.  True, it feels better because we don’t have to feel dumb if we take a risk and it doesn’t work out.  Maybe feeling comfortable is overrated.  If we are truly concerned about outcomes over the long run, often it makes sense to err on the side of aggressiveness rather than passivity.

One of the biggest benefits of a systematic investment process is that it is unemotional.  Our process is designed to expose the portfolios to high relative strength picks–whether it feels comfortable to us or not–simply because research suggests that high relative strength outperforms over time.  If you punt when the chips are down, you won’t have the benefit of the odds working in your favor over time.

—-this article was originally published 11/17/2009.  No doubt we will see some NFL team this weekend make a conservative mistake as well.  Investors, like football coaches, have a conservatism bias due to fear of regret.  Interestingly, the bias toward conservatism often tilts the odds so that being aggressive is the more correct strategy.  Investors often cost themselves money by being too conservative.  The safe choice isn’t always the smart choice.

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Fund Flows

January 19, 2012

The Investment Company Institute is the national association ofU.S.investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs).  Members of ICI manage total assets of $11.82 trillion and serve nearly 90 million shareholders.  Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals.

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