In an era of rapid change over 50 years ago, investment managers with aggressive “open” ways of operating were able to exploit the changes. But that environment would not last long. The beliefs underlying this article would, over time, become obsolete. (Note: Four years out of business school, I was working for a securities firm at the time and was declared too inexperienced by one year to take the third exam to become a Chartered Financial Analyst. This article was made the basis for a three-hour essay question on that exam: “Please comment.”)
Performance-oriented managements have captured virtually all the attention of both individual and institutional investors in recent years and their investment records have been enviable. Are these records luck? Or speculative good fortune? Or only temporary?
Better research and more astute portfolio management are part of the answer, but only part. Like successful companies in other fields, the most rapidly growing and highly regarded investment companies are developing innovative strategies to make the best use of changes in the business environment. Investment managers who seek comparable results should understand the key changes in methods, purposes, and organization which produce sustained superior portfolio performance.
The successful new capital managers have achieved superior operating results because they are better organized for performance than more traditional investors. Their approach is strategic. Effective corporate strategy anywhere usually involves several phases:
The single objective of the new investment management is to maximize the profitability of capital under management. Capital productivity (not capital preservation) dominates the structure and activities of the entire organization, and the efforts of every individual are aimed at contributing to portfolio profit.
Traditional investment managers often have a strikingly different set of goals: Capital preservation (not profitability) is their economic objective. An image of quality and conservatism is sought and protected. They avoid risk. Naturally, these other goals can and often do conflict with a determined effort to maximize money-making.
The new managers are convinced that the traditional organizational structure has important weaknesses that can be reduced or eliminated by changes in management organization and method.
Traditional investment management is oriented towards long-term investments; relies on a committee of senior officers to make all investment decisions at weekly or semi-monthly meetings; depends primarily on a staff of in-house analysts for information and evaluation; and conducts its affairs in private. Since the principal investment objective is capital preservation (rather than capital productivity), caution and conservatism tend to characterize the decision process and the portfolio.
An investment committee has two important and useful capabilities. First, serious errors in judgment seldom survive its open review, because a committee composed of those with diverse experience can usually raise most potentially significant questions. Second, an effective committee can establish sound basic policy. But this does not mean that the committee should also make such operating decisions as security selection, and the degree of emphasis given individual securities.
In portfolio management, time is money, and the necessarily slow decision process of a committee can be very expensive to the portfolio. Memoranda prepared for committees take analysts' time away from productive research efforts. Formal procedures delay actions, often until it is too late to act at all because of price changes. Committee decisions are not easily reversed (although market liquidity allows it) with the result that tentative, experimental purchases are virtually impossible. Profit opportunities provided by market swings must be ignored, and only long-term opportunities can be considered.
Since a committee can only make a few decisions each meeting, they tend to manage portfolios by exception, selling “bad” stocks and buying “good” ones. The new management wants portfolio management by control and recognizes that investment decisions are seldom clearly identified in blacks and whites, but rather appear in varying shades of gray, which warrant almost continuous change in the emphasis placed on various securities. The committee system makes it difficult to assign personal responsibility and measure results. It's not clear who can take credit for good decisions, and who can be held accountable for poor decisions?
An individual investment manager working full-time on the problems and opportunities facing his portfolio can exercise management by control. The logic is in the mathematics of time. A committee that meets for two or three hours 50 times a year cannot make nearly as many astute decisions as an executive working 50 or more hours, 50 weeks a year.
Moreover, if the committee attempts to run the portfolio, it will seldom give adequate time and attention to its major policy responsibilities and will also make inferior operating decisions. So the new management clearly separates policy decisions from operating decisions by assigning operating authority to a single executive or portfolio manager. The capacity to make more decisions allows more aggressive management and allows the portfolio to capture that many more increments of profit. The portfolio manager need not wait for a committee meeting; decisions can be quite informal; he avoids the delays inherent in the preparation of a formal presentation to an investment committee; and he can act decisively.
The competent individual has important advantages over a committee in making investment decisions. Since he devotes all his time and energies to the success of the portfolio, it stands to reason that he'll know more about each constituent security, why it was bought, why it is held, and why it might be sold.
Since portfolio management is more art than science, and since committees are notoriously not artful, the single portfolio executive who is personally skilled in this art will enjoy a significant competitive strength. He can exploit his intuition, inventiveness, and sense of the market because he is judged, not on how well he can explain his programs, but on results in the marketplace.
Moreover, since the portfolio manager is judged on the profitability of the portfolio as a whole, he is more clearly motivated to take sensible risks where the rewards are commensurate. He can act boldly, innovate, and see initiatives to increase portfolio profits. By giving the portfolio manager the authority and direct responsibility for operating decisions, the new managements obtain the advantages of an individual in making and executing decisions while preserving the policy-and-review capabilities of a committee.
The new investment management organizations strive not only to be highly effective at making profitable decisions, but also skillful at acquiring and evaluating the information upon which decisions must be based. The traditional approach to data collection and appraisal relies upon a permanent private staff of analysts who study statistics, visit managements, and write reports recommending purchases and sales to the investment committee. The research process is treated as proprietary and confidential and is considered the sole responsibility of the in-house staff.
While this internal resource can be highly valuable, it can all too often lead to a constriction on the flow of information to the decision-maker. A major opportunity for improved portfolio profit is presented in the best research and security evaluation supplied by brokers. The view that broker research has great value is coupled with a clear awareness of the service buying power of commission generated by the portfolio. The commission buying power is managed carefully and expended to acquire that brokerage research and judgment that will add the most profit to the portfolio.
Another major innovation in capital management is the way in which broker research is integrated into the capital management process. A communications gap exists between the growing store of brokers' research knowledge and the operating needs of the portfolio manager. The portfolio manager who best bridges this communications gap will have an advantage over his competitors.
Whereas the traditional management group insists that all broker research go to the staff analysts, the new approach channels an important part of this information and opinion flow directly to the portfolio manager. This practice derives from an appreciation of subtle human differences between analyst and portfolio manager, their positions within the organization, and how they respond to external opinion.
For many good reasons, staff analysts are usually not well suited to appreciating the merits of broker recommendations. A good analyst is necessarily skeptical and tends to discount what others say. Professionally, he distrusts and disparages relying on the work of others. He knows too much about the particular stocks he follows closely to be impressed by a summary description of other securities, and his professional satisfaction often depends more on the breadth and depth of his company and industry knowledge than on the profitability of recommended purchases and sales. His career development typically depends more upon the consistent accuracy of his earnings projections in research reports than upon the frequency and magnitude of his contributions to the portfolio's profitability. Each year he makes far fewer recommendations than a portfolio manager makes decisions and therefore has a smaller set of commitments over which to obtain a satisfactory average of profitability. And he has less opportunity to reverse his decisions, so he must realistically be more confident of each individual security endorsement. For all these reasons, a staff analyst is ill-suited by position, responsibility, and interest to effectively exploit broker research.
In contrast, the portfolio manager must always rely heavily on the knowledge and appraisals of others, whether they be internal staff analysts or external broker analysts. He is just as receptive to one analyst as he is to another if they can equally increase the profits of the portfolio. His principal skill is in seeing the positive potential in a given situation rather than in identifying possible negatives. Consequently, the contemporary management philosophy offers the portfolio manager wide access to ideas and information, which he may pass on to a staff analyst for review and evaluation if he is interested but not yet convinced or may act upon immediately if he sees opportunity.
Another approach for in-house analysts is to redefine responsibility so that each analyst sees himself as an assistant portfolio manager and concentrates his efforts on flowing profit-making ideas into the portfolio. In this new role, in-house analysts can see broker research as an opportunity to save time, broaden knowledge, and use the best opinions of others. The assistant portfolio manager-analyst will build upon the work of these external analysts rather than recreating their original research, with the strong probability that his annual profit contribution to the portfolio will be greater than if time, efforts, and talents were devoted to independent research.
Beyond recasting the communications net to capture more value from external research, the new management considers outside investment capabilities as an opportunity to improve internal portfolio performance by integrating their knowledge and judgments into the portfolio's management. The most helpful brokers are taken in as effective partners in the management of the portfolio. Their opinions are sought on possible changes in investment policy as well as possible changes in holdings. The result of this “open door” policy is to expand greatly the number of competent persons contributing to the profitable management of the portfolio. With a good understanding of how the portfolio is managed, these outside partners can focus their efforts on providing the particular information and suggestions that are most valuable to the particular portfolio at a particular time.
Trading is an important profit opportunity, and one member of the management team ought to have complete responsibility for it. The experienced trader, involved continuously with the market, not only knows quoted prices but has useful insights into the structure of supply and demand. With this superior market knowledge, the trader is often able to contribute significantly to the profit goal by advising the portfolio manager on timing of actions and on unusual opportunities to buy or sell created by temporary imbalances of supply and demand in the market. New methods have been used to improve the profitability of open market operations, such as large block transactions that allow rapid redeployment of funds in large amounts at specific prices, and sales of blocks to brokers who make position bids by putting their own capital at risk when the market will not immediately absorb a large supply of shares.
The management goal of portfolio profitability is supported with pay and other incentives closely related to an individual's ability to contribute to portfolio profitability. The most important job in terms of income, professional responsibility, prestige, and influence is that of portfolio manager. The personal, non-financial incentives are also important in these free-form, multi-profit-center managements in which each person functions as an entrepreneur, and ability to contribute to portfolio profitability is quickly recognized and quickly rewarded. As a result, the new managements have attracted unusually able, hard-working, and creative young people, and then stimulated them to achievements at or near their potential. As in most fields of organized endeavor, the essential ingredient for sustained superior results is the ability and effectiveness of the people in management, and the new concept of capital management has emphasized the importance of profit-making people.
In summary, having observed and worked with dozens of different investment organizations, I am convinced that the superior record of achievement of a still small but rapidly growing number of capital managements results from their clearer, deeper, and broader understanding of the environment in which they operate and a careful organization of internal strengths to achieve maximum portfolio profits. The flow of new monies to these new managers is impressive evidence that the sophisticated public recognizes their success. Investment managers that are organized along more traditional lines should seriously consider the nature and importance of the new approach to capital management.
Source: Institutional Investor, January, 1968.