This Only Happens at the Bottom and the Top

I’ve got good and bad news for you.

The bad news…David Dreman was fired.

Last week, the trustees of DWS Dreman High Return Fund (KDHRX) announced Dreman would no longer be managing the fund. He managed the fund for more than 20 years.

If you recall, Dreman is a staunch value investor. He is a true value investor who has made his name not getting caught up in the “hot sector” of the day.

In 1980, he literally wrote the book on contrarian investing – Contrarian Investment Strategy: The Psychology of Stock-Market Success – in which he recommended buying stocks. He was also kind enough to sit down with us a few weeks ago to talk about doing something “crazy” at the time – buy bank stocks (view transcript here).

The good news here is…David Dreman was fired.

Now, I’m never happy for someone to lose their job (although he didn’t actually lose his job completely, Dreman still manages many other funds). But, if we look at the history of when legendary fund managers get fired, it’s a very good sign for those of us with both short and long-term time horizons.

Lessons Never Learned

The markets have a funny way of making smart people do dumb things. It’s been going on for centuries. This time is no different.

Back in 2000 the markets were soaring to new highs. In fact, that March the NASDAQ passed 5000 and “everyone was making a lot of money” – or so it seemed.

George Vanderheiden was one of the few who were not making a killing. Vanderheiden was one of the star stockpickers at Fidelity Investments. In 2000, he managed a few funds responsible for the oversight of more than $35 billion in assets.

At the time, it appeared Vanderheiden lost his touch after an impressive 20 year run with the firm. The top holdings in his Fidelity Destiny I Fund were among the most boring investments imaginable. The largest holding in the fund was U.S. Treasury bonds. The fund’s third largest holding was Philip Morris (now, Altria – NYSE:MO) which was decimated by legal problems at the time.

Vanderheiden’s philosophy was simple. He said:

“What I try to do in managing a fund is manage both the risk side and the reward side. When valuations get stretched as they have over the past few years, I kind of tilt the portfolio toward managing for risks.”

That simple philosophy wasn’t paying off during the tech boom though. The Destiny I Fund gained a meager 5% in 1999. Meanwhile, the S&P 500 returned 21.1%.

The herd mentality was summed up by commentator James Lowell:

“George’s reluctance to incorporate the new economy into the overall scheme of his investment discipline has clearly hurt him. [Vanderheiden’s story] is a cautionary tale of a manager that seems to be unwilling to change his stripes in the face of a market that has clearly changed its stripes.”

Growth stocks were in. Value stocks were out and so was a value-minded investor like Vanderheiden. Two years later that would all change.

A Sign of the Times

Vanderheiden was let go – err, “voluntary retired” – at pretty much the top of the market. It’s when he would have felt the greatest pressure from his managers to switch to a more “popular” strategy as well.

His unwillingness to “change with the times” was not rewarded. Neither was Dreman’s.

In his 1980 book, Dreman wrote:

“Investors repeatedly jump ship on a good strategy just because it hasn’t worked so well lately, and, almost invariably, abandon it at precisely the wrong time.”

The same is true for investment firm managers as well. Remember, the managers of mutual fund companies (not the investment managers of the funds which pick the stocks, bonds, etc.) are responsible for growing the business. Since more mutual fund companies are paid on a percentage basis of the total assets they manage, not on performance, they have to get more money in the door.

The more money they manage, the more they get paid. That’s why the managers are the salespeople and marketers who want to get as many dollars in their funds as possible. They want more investors with more money to generate more management fees.

So to be successful, they’re faced with a choice between the short-term and the long-term.

The Easy Way or the Hard Way

Some opt for the long-term perspective. They hire top talent who can deliver consistent performance. They often let the “numbers do the talking” in their ads. And they don’t focus on the quarter-to-quarter results. They know if they build quality funds, new investors will follow, and they’ll stick around.

Others are more focused on the short-term. They create new funds in hot sectors to attract more capital. They spend big on advertising. And the advertising expenses are just pushed onto their fund shareholders for higher fees.

They feast on big scores like “One-year performance – 87%” in order to help attract new money into the fund. For example, think back to early 2008. A mutual fund company would have attracted a lot more money into some China-focused Fund which just doubled in 2007 (and new investors would therefore expect it to double again and again) than some underperforming value stock fund.

But hey, that’s the business. There’s nothing wrong with it as long as you know their incentives. And in the mutual fund industry, all too many times the highest short-term incentives are to sell average investors what they want – not necessarily what is good for them.

The Toughest Action to Take

That’s why the news of Dreman’s ousting is both good and bad.

His tried and true value approach was a leading performer sometimes and a laggard at other times. Over the long-term, it was a winning strategy and Dreman was sticking to what he knows works regardless of the overall market movements.

According to Floyd Norris of the New York Times:

“I checked the fund’s last 14 annual reports, each of which showed its performance relative to Lipper’s group of equity-income mutual funds. In seven of those years, it was in the top quartile. In four of them, it was in the bottom quartile. Only in three of the years did the fund end up in the middle 50 percent of funds.”

Basically, it’s Dreman and value out; new managers and a “flexible value approach” in. They’re looking at the short-term.

Will it work? Frankly, only time will tell. But if history is any indication, the managers with their new approach probably won’t do any better than Dreman over the long-term.

After all, the last time Dreman’s value approach performed so poorly was the same time Vanderheiden’s approach was lagging as well. According to Bloomberg:

“Dreman trailed the S&P 500 Index by 34 percentage points during the Internet boom in 1999, only to beat the U.S. benchmark by 50 percentage points when the technology bubble burst the following year.”

That’s why I was very interested when I heard Dreman was getting bumped from his flagship fund. When the world’s investing legends seem to have “lost their way,” chances are they’re about to find it again soon.

Avoid the Noise

Over the short-term, I still think there is plenty of room for this rally to continue on for a number of reasons. As we’ve looked at over the past few weeks, there’s still a lot of money on the sidelines under the watchful eye of managers just itching to “put it to work.” The herd appears to be waiting for this rally to end. There are still very few believers in this rally and everyone is just waiting for it to end. As we’ve seen time and time again, nothing happens in the markets when everyone is watching for it.

So when the markets are still volatile, I remember the words of Charlie Munger, Warren Buffett’s number two man at Berkshire Hathaway. He has stated many times:

“Half of Warren’s time is sitting on his ass and reading the other half is spent talking on the phone or in person to highly gifted persons that he trusts and trust him.”

That’s exactly what I do every day. I’m still looking for opportunities. I’m looking to buy stocks and find trading opportunities according to my plan. But that’s about it.

As for every sound bite, press release from the banks, and comments from world leaders which drive the markets every day, I just sit back and view it all as nothing more than idle noise. I hope you do the same.

By Andrew Mickey

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