Bull!

by Maggie Mahar

  A. Michael Lipper, founder of Lipper Analytical Services, agreed that when it comes to telling the difference between luck and talent “you’re moving [away from the science] and into the ‘art’ of mutual fund analysis.” Unlike Morningstar, Lipper’s rankings did not give more weight to three-year performance. Nor did they try to rate funds with a star system. “We called our analysis ‘rankings’ rather than ‘ratings’—all we were doing was showing an array, we were not casting a judgment,” Lipper explained in a 2003 interview.31 “Ultimately, you want to look at what created the performance,” he emphasized. “In many cases, you’ll find that a few very good or quite bad decisions made all the difference. For many fund managers, the good ones came early in their career—and if people lengthened the time period they were looking at, the good performance at the beginning would carry the long periods. What you want to do is look at the manager’s performance period by period—and try to assess how repeatable it is.

  “To me, the managers who showed repeatable results during the bull market were Peter Lynch, John Templeton, and John Neff,” Lipper added.32 “Over the years, they succeeded while investing in different securities. By contrast, a number of managers did well by investing in the same 100 stocks for 30 years, 60 of them at a time. They weren’t finding new names,” making it harder, Lipper suggested, to assess their talent as stock pickers. Maybe they just got lucky when they first chose their stable of stocks.

  Even over long periods of time, virtually everyone who has tried to analyze investment talent agrees, it is impossible to know how much of a mutual fund manager’s success is due to skill, and how much is what options trader Nassim Nicholas Taleb calls “survivorship bias.”

  “We look back at investors who have made a lot of money and we tend to think ‘they made it because they were good.’ Perhaps,” Taleb observed, “we have turned the causality on its head: maybe we consider them good just because they made money.”

  In Fooled by Randomness: The Hidden Role of Risk in the Market and in Life, Taleb offered a wonderfully ghoulish example to illustrate his point: “Imagine an eccentric and bored billionaire who offers you $10 million to play Russian roulette. He gives you a revolver with six chambers, a bullet in only one of those chambers, and challenges you to hold it to your head and pull the trigger. Chances are five in six that you’ll come away with $10 million; chances are one in six that you won’t come away at all. In other words, there are six possible paths that your story will take—but after the fact, we’ll see only one of them.” And if you survive, Taleb observed, “you may be used as a role model by family, friends and neighbors.” Indeed, if the Russian roulette player was a mutual fund manager, some journalist might well put him on the cover of a magazine (“Savvy Risk-Taker Beats Index”).33

  Of course, Taleb conceded, if the roulette-betting fool kept on playing the game, the alternative story lines would be likely to catch up with him: “Chances are, he wouldn’t survive to his 50th birthday. But when we look at the stock market’s stars we’re looking at the survivors from a very large pool of players. Imagine that there are thousands of 25-year-olds willing to play Russian roulette, playing each year, on their birthdays. At the end of say, twenty years, we can expect to see a handful of extremely rich survivors—and a very large cemetery.

  “But that small group of survivors would be hailed as winners—the alternative possibilities of what might have happened to them would be ignored.”34

  Yet maybe they were just lucky—after all, someone had to wind up in the top percentile. This applies not only to mutual fund managers but to the funds themselves. For instance, imagine that in 1987 there were 30 mutual funds in the United States devoted to investing in technology, and that over the next 15 years, 6 of the original 30 produced average returns of more than 12 percent a year. Meanwhile, the other 24 funds averaged less than 5 percent and either were closed or folded into other funds. We would look at the 6 that survived and say that investing in technology funds is not so very risky: after all, on average, technology funds with a 15-year track record returned 12 percent from 1987 to 2002.

  That said, Hulbert’s research suggests that information about a stock picker’s performance over a very long period can be valuable. Taleb agreed. If an investor flourished over a long period of time, surviving more than one cycle, it is fair to presume that more than luck was involved. “George Soros, for example, succeeded, not only in very different cycles, but in very different markets—trading not only U.S. stocks, but currencies and foreign equities,” Taleb pointed out. This makes it more likely that his success was due to skill. But, “you cannot be certain,” Taleb added. “You can only make the presumption that it was more skill than chance.”35

  Information is, in the end, always imperfect. No matter how much data an investor has, he never knows what piece might be missing. And in the mid-nineties, the available information about the talents of individual mutual fund managers was far from complete. Indeed, very few fund managers had been on the job for 15 years.

  BRINGING INDEPENDENT RESEARCH TO A WIDER AUDIENCE

  As the market lifted off, the Age of Information seemed to be failing the small investor, providing an embarrassment of information—and too little knowledge. Some would blame the investor himself. After all, if thoughtful financial analysis drew a wider audience, it might well be less expensive, and therefore more available to small investors. No doubt, many of the best newsletter writers of the nineties would happily have published their reports more widely, at a lower cost. But the truth is that the majority of investors preferred the lighter fare to be found in the mainstream press—or in popular newsletters such as Louis Rukeyser’s Rukeyser Report, which offered generally upbeat, easily digested commentary at an affordable price.

  Others would argue that if the best research were more widely read, it would, almost by definition, become less valuable. Those who read it would no longer enjoy an “edge” over other investors. But this is true only if one assumes that the most valuable information consists of “tips”: buy X, or sell Y. In this case, whoever gets the news first winds up the winner.

  Ideas, on the other hand, have a much longer shelf life. Tice’s analysis of Sunbeam, for instance, was far more than a sell recommendation. He drew a portrait of the company in the context of both the small-appliance industry and Sunbeam’s own past performance. This was not a “tip” or a “scoop”—Tice simply analyzed publicly available information. What made the report so valuable was his ability to synthesize that information, ignore the noise, and underline what was most important.

  Investors who had access to his report did not need to act on it immediately. They simply needed to do what Tice had done: think about it. Four months after he issued the report to his own subscribers, Tice shared the essential information about Sunbeam with Herb Greenberg—and at that point, it was just as valuable to an investor who read Greenberg’s column in Fortune as it had been to Tice’s subscribers. Sunbeam’s shares were still flying high—and would climb higher. Investors had more than a year to act on Tice’s warning.

  Over the long run, the market may be efficient, but often it takes months—or even years—for the stock market to absorb the implications of publicly available information. This is why the best investment research tends to have lasting value, not just to the investors who get the news first but to anyone willing to reflect on it.

  To their credit, some in the mainstream press tried to bring first-rate financial analysis to a larger audience, publishing the independent views of seasoned market observers such as Russell, Grant, Hickey, and Tice—picadors who challenged the bull and threatened to prick the bubble.

  But as the bull barreled ahead, critical thinking became less welcome, not only on Wall Street but on Main Street. More often than not, the press conferred authority on the bulls, quoting Abby Cohen, Ralph Acampora, or Salomon Brothers telecom analyst Jack Grubman as “experts” in front-page news stories. For balance, many newspapers and magazines made
room for a bearish voice, but the skeptics’ arguments were usually consigned to op-ed pieces, columns, or “Q&A” interviews—bracketed in a way that made it clear that the views expressed were the opinion of just one dreary man.

  After all, the bull market of the mid-nineties was a democratic market. Any publication that questioned the market’s rise was questioning the collective wisdom of its readers—the individual investors who were pouring their retirement dollars into stocks and stock funds. “Our new-found faith in active, intelligent audiences made criticism of the market philosophically untenable,” wrote social historian Thomas Frank.36 Skeptics came to be seen as cynics—doubters who dared to question the judgment of millions of individual investors.

  HOW THE CONVENTIONAL WISDOM ABSORBS INFORMATION

  In truth, however, those individual investors were not making separate judgments. The vast majority were swayed by the same headlines: sound bites that were, at best, incomplete—at worst, hype. Yet precisely because everyone shared the same information, investors enjoyed a false sense of security: “Everyone knew” that, over time, stocks always went up. Ergo, if you just bought a good company and held on, you would make money—no matter what price you paid for the stock.

  This was the conventional wisdom of the time. Such truths seemed self-evident. Similarly, in the late seventies, “the death of equities” was the headline that summed up the prevailing view.37 “Everyone knew” that real estate was the best hedge against inflation. And, for a time, that would be true.

  The problem is that as circumstances change, so does the conventional wisdom. Yet at any given cultural moment, we accept it as absolute truth.38

  Even in an Age of Information, we make the facts fit the conventional wisdom. The trade deficit has broken yet another record? In a bull market, this is assimilated as good news: “The consensus among economists is that the trade gap is a reflection of the U.S. economy’s position as the strongest in the world,” Bloomberg News reported.39 Price/earnings ratios have hit an all-time high? This was taken not as a warning that stocks might be overvalued, but as further proof that the old rules no longer applied.

  Particularly in the midst of a financial mania, the received wisdom creates the illusion that there is safety in numbers. So, in the late eighties, Japanese investors buying near the peak of their own bull market liked to cite a popular Japanese saying: “If we all cross on the red light together, there’s no need to be afraid.”40

  In a sense, they were right. For the moment—and at the time, the moment was all that seemed to matter—momentum was on their side. This is why, late in 1996, Richard Russell advised his readers that the bull market still had legs. “Once in every decade or so we see a market move that seemingly has taken on a ‘life of its own.’ We are seeing one such move now…. For the first time in history, the capitalization of the U.S. stock market is greater than the entire U.S. Gross Domestic Product (the stock market is now valued at 101% of GDP; for comparison, the average in past history is 47.9%).” This bull, Russell knew, would not turn on a dime. It would need to make a long, extended top—even though many stocks were already grossly overvalued.

  “In this business, it’s easy to be fascinated with what ‘should’ or ‘should not’ happen,” Russell cautioned. “The reality is that the Dow and the broad S&P have set new record highs. The rise has been confirmed by the advance-decline ratio on the New York Stock Exchange [which showed that the majority of stocks were still rising] and led by my Primary Trend Index.” Russell could see that the underlying trend continued to be strongly positive. The tide was still coming in, even though it was sheer momentum, rather than value, that was driving the market.

  But Russell also knew that, in the long run, everything depends on value: the price you pay when you get into the market. So, while he urged readers who already were in the market to ride the wave, he warned that prices were now so high that it was too late to join the party:

  “If you’re out of stocks, stay out; it’s too late to be a hero, but it’s not too late to be a loser.”41

  —11—

  AOL: A CASE STUDY

  By the fall of 1995, America Online’s shares already had taken wing—up 2,000 percent since the company’s initial public offering just three years earlier. In a market driven by momentum, AOL was a star. But Allan Sloan realized that AOL’s continued success depended upon its ability to stay a step ahead of the shorts. By Sloan’s reckoning, the company was running a cash deficit of about $75 million a year. Meanwhile, the company was covering its financial shortfall with perfectly legal—but misleading—accounting techniques.

  In other words, AOL was gaming its books. Everyone on Wall Street knew it, but most investors were content to ignore it. After all, in the first nine months of 1995, AOL had shot up 135 percent. Who wanted to quibble about bookkeeping?

  Sloan wanted to make sure that his readers understood the risk: “Look closely and you see that AOL is as much about accounting technology as it is about computer technology,” he wrote in October of 1995. “So make sure you understand the numbers before rushing out to buy AOL.”

  That fall, AOL was trying to paper over its cash deficit by issuing more and more stock. “If AOL can’t sell stock, it’s got big trouble,” Sloan warned his readers. “At the least, it would have to drastically scale back its expansion plans.”

  Just as the operator of a pyramid scheme needs to continually bring in more customers, AOL needed to keep on issuing and selling new shares to keep the cash flow coming. Without the fresh money, the pyramid would collapse. This put AOL in a precarious position: “On Oct. 10 AOL raised about $100 million by selling new shares. The company sold the stock even though its shares had fallen to $58.375 from about $72 in September when the sales plans were announced,” Sloan noted. “Most companies would have delayed the offering, waiting for the price to snap back. AOL didn’t, prompting cynics to think the company really needed the money.”1

  Sloan had hit the nail on the head. AOL was papering over what should have been reported as losses with accounting tricks while covering its cash flow deficit by selling stock. Meanwhile, AOL tried to keep the dollars flowing in by charging up to $9.95 monthly for just five hours of Internet access—plus $2.95 for each additional hour online. But AOL executives knew that game could not go on forever. Already, a price war had begun. Six months earlier, one of its chief rivals, Prodigy, had announced a plan offering 30 hours of service for a flat fee of $29.95.2 By 1996, AOL’s competitors would offer unlimited use, at least during off-peak hours, for $19.95. But AOL resisted the notion of unlimited access for a flat fee.

  AOL dragged its feet because it needed the revenues that it racked up from customers who used its chat rooms—online forums that allowed a freedom of expression that its biggest competitors, Prodigy and Compuserve, eschewed. On AOL, “sex chat” dominated many conversations. AOL users could take online aliases and roam unchaperoned chat rooms where it was easy to attach graphic files, making the site a convenient place to display porn. Members could even create their own chat rooms, with names like “submissive men” (as well as private rooms that a subscriber could enter only if a like-minded user had given him the code). AOL did not police the private rooms, and there, pornographers could flash their wares with impunity.

  Not surprisingly, sex chat proved addictive. AOL’s $2.95 per hour charges added up. In aol.con., Kara Swisher, who covered the company for The Washington Post and, later, for The Wall Street Journal, reported that “chat,” of all kinds, accounted for fully one-fourth of all member hours online, and some AOL users would spend more than 100 hours a month online.

  “‘That’s why AOL had eight million members and Prodigy has faded to a shadow of its former self,’” grumbled a high-ranking executive at Prodigy. By 1996, AOL’s “heavy users” accounted for just one-third of its subscriber base but counted for 60 percent of online hours. Rolling Stone magazine reckoned that, assuming half of AOL’s chat was sexually oriented, the company now was r
aking in up to $7 million a month from “sex chat” alone. In the same article, Steve Case estimated that less than one-half of all chat was sex related.3

  AOL was not alone in relying on pornography to generate traffic. “Porn was also very important for Yahoo!” said an analyst who covered the company in its early years. “It got the hours up—and no one talked about it.”4

  But sex chat alone was not enough to keep AOL in the black. To conjure up profits, AOL relied on a form of creative accounting that CUNY accounting professor Abraham Briloff would describe as “in-your-face arrogance.” Two months before Sloan published his 1995 story, Briloff delivered a scalding paper at the American Accounting Conference revealing what short sellers on Wall Street already knew: AOL did not subtract the cost of marketing its product from its annual profits. Instead, the company categorized the millions it spent while recruiting customers as “deferred subscriber acquisition costs,” and booked the expense as an “investment” to be paid for over a period of years.

  In other words, AOL treated the costs of marketing the way a manufacturing company might treat an investment in factory equipment. Such investments are subtracted from profits over a period of years. The difference is that five years later, the manufacturer would still have the equipment. By contrast, in 2000 AOL would have relatively little to show for the advertising dollars it spent recruiting customers in 1995: five years later, many of those customers would have moved on to a different service.

  And AOL’s marketing costs were staggering. For AOL was all about marketing. After all, the company’s chief executive, Steve Case, had learned how to sell a product at the Harvard of marketing: Procter & Gamble. Straight out of college, Case began his career promoting hair-care products at P&G (where he contributed the phrase “Towlette? You Bet!” to the English language), then moved to PepsiCo, where he worked on the Pizza Hut account. Case was not with either company for long, but he learned the basic strategy of introducing a product. He also understood that if you give the American consumer something for free, he might be so pleased that he would spend money to use it. Thus, in 1994, AOL began its campaign to win its way into the wallets of America’s Great Unwired by giving away hundreds of millions of free floppy disks.5