a marvelous job in convertible bonds;etc. We also have a wonderful individual in the gold fund; a wonderfulindividual in the growth area, Howard Ward, who is a world classprofessional under the mantra of growth. That’s part of the othermantra of the firm, which is to take the Gabelli brand and leverageit to create niches.
Tanous:Here’s a softball question. Which activity do you like better?
Gabelli: The ideal world is a growth stock selling at below its in-trinsic value. That’s what we look for. There’s no virtue in buying acompany that’s selling at a dollar when it’s worth two dollars if tenyears later it’s selling at a dollar fifty and it’s still worth two dollars.What you want to do, within the mix of private market value invest-ing, is find the company that’s selling for a dollar and is worth twodollars where the two dollars will grow at least faster than inflationplus our hurdle rate. [The hurdle rate is the minimum risk-adjustedrate of return that makes an investment worth the bother.]
Tanous:Are we talking “catalyst” again?
Gabelli: No! You're talking fundamental valuations. You're talkingabout when you value an enterprise and you say it’s worth two dollars,and that’s the private market value, but it’s selling at one dollar. That’sa snapshot. Then you need a motion picture. What will that two dollarvalue be in five years? That is, will the value grow? So, getting back,a value investor like myself wants a business franchise that will growin value over time. Revenues will grow, EBITDA [earnings before in-terest, taxes, depreciation, and amortization also sometimes looselyreferred to as “cash flow.” Most private market purchasers look atEBITDA multiples in preference to price-earnings multiples] will grow.Ideally, EBITDA margins will grow, but you don’t need that. In thatframework, cash flow is used to reduce debt, enhancing the enterprisevalue. You go from a dollar value, to a two dollar value, to four dollarsof value, and, in theory, from one dollar in the public price to fourdollars.
Tanous:So here we’re not talking about “catalyst,” we’re talkingabout fundamental improvement in earnings; fundamental improve-ment in other financial measures.
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Gabelli: Yes! It is the microeconomic variables that go into makingthe intrinsic value of the enterprise. Going back to your question,Peter, there was a quant and an index guy at a conference like theones your academics attend, and they were debating which style wasa better virtue, in terms of investment process, and the debate wasgetting very heated. All of a sudden the ground shook, and they sawa piece of paper gently floating down from the sky. They looked atit and it said: Quants and indexers are equal. Signed: God, Value In-vestor [lots of laughter].
Anyone who buys a stock based on earnings dynamics alonewithout looking at it from a price point of view is a momentum in-vestor.
Tanous:I’ve got one in the book, Richard Driehaus.
Gabelli: Richard is one of them. His shop is very good at it.
Tanous: You also have bred “personalities” within the Gabelli em-pire, if I can call it that. Elizabeth Bramwell, who used to run yourgrowth fund, comes to mind. But there are pluses and minuses tocreating personalities, aren’t there? You create a personality, andthen they leave.
Gabelli: That’s okay. I mean, I left Loeb Rhodes. Driehaus left A.G.Becker to start his own company. Everyone leaves sometime. DickStrong, who founded the Strong Funds, left. But basically the answeris simple. I hired Elizabeth Bramwell as an analyst, and then I madeher my research director. She was my classmate at Columbia and wealso worked together at William D. Witter. As a result, I knew herinvestment skills.
But the point is that you need personalities to compete against Fi-delity, Dreyfus, and Vanguard. As a result, we also believe that peoplerun money, and they are part of an organization and a process. |launched Elizabeth as a personality. And she was a growth investorjust like Howard Ward is. Within that framework, we like personalities.I will continue to help advertise personalities. Caesar Bryan is awonderful personality. He’s a Brit, lawyer, good background. He lovesstocks, and he loves precious metals and golds, and he is world class.We think Hart Woodson is one of the best in the convertible bondarea. It’s a niche that few people understand. It’s like fly fishing.
Tanous:Can I tell you a funny story?
Gabelli: Go ahead.
Tanous:! interviewed Michael Price and we went through this whole
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business about International Mining, and Kawecki, and Fansteel, andhe told me about how he put together this great chart back in 1976about the relationships between all these companies. Let me quotefrom the interview: “One of the brokers in Max’s brokerage firm wasthis guy who is a friend of Mario Gabelli, whom I had never met.Mario at that time was a broker at Loeb Rhodes. Mario walked overto my desk and took the chart and walked out. I said where are yougoing with that? He took that chart of the complex of companies. Itwas so funny. That’s how I met Mario.”
Gabelli: Well, maybe the story is backwards. I think we met becauseI was looking to buy furniture cheap and his firm was going out ofbusiness. | bought three desks from, I believe, Heine Geduld, for ahundred dollars each when they were going out of business, and Iwas starting my firm in 1976. I couldn’t afford to buy them wholesale,so I bought them below wholesale.
The report Mike refers to is basically the same report that MutualShares used without paying me a commission on it. But Michael’s agood guy. Michael comes to research dinners I sponsor, and I go toMichael’s dinners, and we share a lot of stories, and he’s a friend.He’s a good value investor and we’ve been on Barron’s panels for thelast 12 or 13 years.
Here’s another insight. Two professors from Tulane did a study todetermine who picked the best stocks on the Barron’s panels for tenyears. I’m obviously mentioning this because | was number one!
Tanous: You have an intriguing and whimsically named fund called“Gabelli Global Interactive Couch Potato Fund™.” Tell us about it.
Gabelli: A couch potato is a guy who went home with a six pack,four for him, two for his wife, and he sat on the couch and watchedtelevision. Then the remote control came along, and that startedchanging America’s appetite. Instead of just sitting down and turningon channel 2 and watching it for a four hour block, the couch potatostarted grazing and surfing - all thanks to the remote. But then whathappened about five years ago was that the advertisers started tryingto get the TV viewer to interact with the TV set. For example, scratchoff something and look at it while Coca-Cola is running an ad duringthe Super Bowl.
Because we have an area of competence in global entertainmentand media, which is one of the strong suits of our firm, we just coined
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the term “Interactive Couch Potato™”, but that is strictly an Americanphenomenon. Europeans don’t know what it is yet.
Tanous:As an investor, what am I looking for in that fund?
Gabelli: If you look back over the last ten years, and look forwardto the next 20, one of my great themes of investing is the concept ofthe notion of time and place. Wireless communication has changed,unshackled and uncoupled man from a place. You can be anywhere,any time. It is wonderful. It is changing the way humanity commu-nicates, the way humanity functions, where people live and work.You still need food, but you can have it FedEx-ed! So we’re lookingat the world in terms of cable, which is televisions, voice and video,data, and we’re also looking at it from an unwired point of view. Thedistribution of information is going through a major change. Somecountries are getting it for the first time; other countries are findingnew ways to communicate.
On the copyright side, taking ideas putting them together, it’s thesame thing. So we’re looking on a global basis for things that travelwell around the world - like music, MTV, jazz, films, sports, news,entertainment. Then, we’re looking for the facilitators, like Microsoftthat can put devices together to allow it to happen in multimedia.Our fund is doing this on a global basis. I think we’re good at it andunique. We bring to the table a knowledge of all of these disciplinesthat no other firm has. If markets around the world grow 10% peryear over the next ten years, we think this fund should be able to doabout 15% per year.
Tanous: This is why I wanted to spend some time on it. Mario, whatdoes the future hold for you? Are you going to do this forever?
Gabelli: About ten years ago, the Harmonie Club had a breakfaston a Saturday morning in the middle of February, a very snowy day,and there were four panelists: Seth Glickenhaus [Glickenhaus & Co.],Roy Neuberger [Neuberger and Berman], Tubby Burnham [DrexelBurnham & Co.], and me. Tubby gets up there and says “I’m TubbyBurnham, I’ve been in this business 50 years, Roy Neuberger’s in thisbusiness 60 years, Seth Glickenhaus 60 years, and here’s Mr. Gabelli,only 25 years.” So I said, I thought I was invited to this club becauseit was politically correct to invite me! A sign of the Harmonie Club’saffirmative action! But it was really basically because of my age! [TheHarmonie Club is a prestigious, largely Jewish, club.] And it was alot of fun. What I’m getting at is that every one of us didn’t have to
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be there. We loved the market, we loved what we were doing, andthis is over ten years ago! So, if I’m doing this forty years from now,Pll be 95, itll be 2036, and we'll still be debating value versus growth,and which has the greater virtue.
I wonder if Gabelli’s hyper energy came through in the interview?I suspect it did. One has the sense of an individual who would riseto any challenge. Mario, have you tried bungee jumping? I came awaydutifully impressed by his enthusiasm and energy level. There seemslittle doubt that Gabelli also oversees every aspect of his business.You wonder when he finds time to sit back and do the analysis ofcompanies and stocks that has historically been his forte. Yet he doescontinue to do that, while building a firm that has expanded wellbeyond the original value mantra that its founder espouses.
Gabelli’s philosophy on companies is also very interesting. His“catalyst” notion is an intelligent and sensible approach to the market,wouldn't you agree? After all, it’s one thing to find an undervaluedcompany. It’s quite another to find one that is not going to stay un-dervalued indefinitely. The difference, of course, is the catalyst - thatfactor that will cause the stock price to rise - and Gabelli intelligentlyincludes it in the analytical process. Gabelli’s notions about the futureof telecommunications in a wireless world also bear watching. So herewe have a value investor with a twist. He finds undervalued compan-ies, as do most value managers, but he also tries very hard to find theones that aren’t going to stay undervalued very long, the ones with a“catalyst.” Makes sense to me.
79WILLIAM F. SHARPE
Does anybody start out to be an economist? That reminds me of theold joke: an economist is someone who didn’t have the personality tobecome an accountant. Yuk Yuk. Bill Sharpe didn’t start out to becomean economist either. He really thought he wanted to be a doctor, butquickly changed his mind. Instead, he earned his B.A. and M.A. ineconomics at UCLA.
His association with Harry Markowitz, who became his mentor,began in 1960 when Bill Sharpe undertook his graduate work on therelationship between the movement of individual stock prices and themovement of the stock market as a whole. The breakthrough came in1964 with the publication of the Capital Asset Pricing Model, knownas CAPM, which, among other things, concludes that you can’t reallybeat the market without taking undue risk - exactly what legions ofWall Street analysts and brokers did not want to hear. Thirty yearsafter they first began working together, Harry Markowitz and BillSharpe shared the Nobel Prize for economic sciences with Dr. MertonMiller of the University of Chicago.
Bill Sharpe is about as close as anyone can come to being ahousehold name on Wall Street, at least among the academics whoutter pronouncements on matters affecting the stock market. He con-tributed beta to the investment vocabulary, as well as the eponymousSharpe ratio, a widely used measure of risk-adjusted investment return.
Talking to Nobel prize winners is something one might understand-ably approach with a sense of trepidation, but I found Bill Sharpeunusually easy to talk to. You will too. He offers some interestingadvice on investing, which we will tuck away for future discussion.
Tanous:How did you first get interested in stocks?
Sharpe: As an undergraduate economics major, I thought that if Ilearned something about the stock market, I could make a lot ofmoney. So, I took a course in investments, which I found totallyopaque. It was taught by a very nice man, but it was really old fash-ioned and had no structure or theory. That was just the way we usedto approach investments: you learn how to read a balance sheet; youcompute all these ratios; you think about the management; and youdo some kind of mumbo jumbo. I thought that was very uninteresting.INVESTMENT GURUS
I was an economics major and I was used to logic and structure andtheory, and I didn’t see any in this process. So, that was that. I wenton to a research firm, and then went back and got a Ph.D. in econom-ics.
But here’s the key thing: When I was doing my masters in econom-ics [ was a research assistant for J. Fred Weston who was not in in-vestments, but in corporate finance. Weston was a very smart guyand solid as a rock. So I got interested in finance - not so much ininvestments per se, but in finance. I took my Ph.D. in economics, andI took a field in finance - which was unusual, but allowed under therules.
Along the way, I learned about Harry Markowitz’s work, which Ithought was really nifty because it had all the great theory andstructure that I liked. When my first dissertation project didn’t excitethe faculty member who would have been the supervisor, Fred sug-gested that I talk to Harry Markowitz, who was not on the faculty,but was working at the same research firm I was working at. See ifmaybe there was something there. We chatted, and I got excited aboutsome ideas. I did a dissertation on portfolio theory, extended it toequilibrium and the capital markets, and the rest is history.
Tanous:I was very interested in your 1990 Darden School [TheUniversity of Virginia’s business school] lecture on asset allocation.You mentioned Fidelity Magellan’s superior performance from 86 to89. Fact is, you cited its great performance, indicating that PeterLynch had, in fact, demonstrated outstanding stock selection ability.[See our next interview on page 111, which is with Peter - who be-came a legend as the extremely successful manager of FidelityMagellan.]
Sharpe: I define selection as total return, minus style return. [Forexample, growth stock returns versus value stock returns, since theybehave differently.] Yes, he beat the benchmark that style analysis,run through time, would put him against.
Tanous:The interesting thing to me is that [I don’t know if yourstudy has been updated since ’89] in the case of Fidelity Magellan, itseems to me that the outstanding performance continued.
Sharpe: Hold on a second. I'll look it up. [Sharpe turns to hiscomputer and begins punching keys to search for the relevant data.]This is a commercial data service so I’m not implicated! Let’s see...thisis it...Okay. Fidelity Magellan. Found it. We'll do a sample and we'll
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analyze style...we’ll do out of sample...we’ll update quarterly...howabout that?
Tanous:Perfect.
Sharpe: Let’s see. Starting in early 1993 [the years Jeff Vinik wasmanaging Magellan], it shows “outperformance” then flat, then downa little - this is relative to the benchmark - then flat, then down alittle again, then basically they had only added about 5% in 93 and°94, But, then, in the first part of 95 they did so well. That was thebig move into tech stocks we all read about.
Tanous:The question is; is Peter Lynch a great manager or is hethe millionth monkey?
Sharpe: Morris Smith was the second Magellan manager, and heactually had a better style-adjusted record in the Fidelity OTC Fund- which he ran before he took over Magellan - than Lynch had inMagellan at that time. If you look at Fidelity equity funds in generalyou'll find that they’re not bad. There seems to be a little somethingthere.
Tanous:How do we rationalize the “little something”?
Sharpe: Some of the competitors used to say that the way they didit was to run up the prices by buying such huge amounts! Maybethat’s why Lynch resigned because he didn’t want to have to sell anyof that stuff! But I don’t think we have a lot of evidence that that’sit. We’re not talking about blowing out the lights. The good perform-ance isn’t in every Fidelity fund. Some of their funds underperformand some overperform. I haven’t done this, but I’ll bet if you took adollar-weighted portfolio of the Fidelity equity funds - before loadfees at least - you probably would be in pretty good shape. You wouldprobably get close to, or maybe even beat, the indexes.
Tanous:But who else can I ask but you? Why and how do we pickthese funds?
Sharpe: In any negative sum game, the average is going to benegative because of cost, relative to benchmarks. There will be somethat win and some that lose. Recently a number of us have turned upsome evidence of persistence in fund returns.
Tanous:Aha!
Sharpe: Marty Gruber has [Gruber is a professor at the NYU SternSchool of Business]; 1 have. If you look on my web site you'll see astudy I did. [Bill Sharpe’s home page web address is: http://gsb-www.stanford.edu/~wfsharpe/home.htm]
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Tanous: What all of this comes down to is a couple of investmentmysteries. One is the predictability of future performance. This is whatit’s about, isn’t it?
Sharpe: Of course. There are two issues. One is: Are you gettingthe asset allocation you wanted? If you decide you want a value tilt,you hire some managers. Do you get a value tilt? That’s an issue ofstyle and aggregation. That’s independent of performance. The secondis: You pay managers more than if you invested in Vanguard Indexfunds. So, you’ve got added risk and cost. But have you gotten enoughadded return to warrant doing it?
Tanous:Fair enough. I read a piece you wrote in which you veryelegantly make the case that after costs, the return on the averageactively managed portfolio must be less than the return on the averagepassively managed portfolio. A wonderful piece.
Sharpe: When I speak in front of an audience that hasn’t been ex-posed to much of this, I like to play a game. I do this little routine inwhich we divide the room and a third of the audience are passivemanagers, and two thirds are active managers. And they collectivelyhave all the money in some market - French equities, whatever. Iannounce what the return was on the market last year, last month,or yesterday, it doesn’t matter. Then I ask them, before costs, how didthe passive guys do? Well, they did so much. How about the activeguys? Well, gee, | guess they had to do the same, and, after costs,they had to do worse.
I usually dramatize it by saying the passive people are really boring,all they really know how to do is count to 500 [Sharpe is referringto the S&P 500, which is often used as the benchmark for passiveinvestors], or look up how many shares are outstanding. Hope younever get stuck at a cocktail party with them. On the other hand, theactive managers are fascinating and charming, they know all aboutthe latest products. They’re so interesting and so intelligent. It makesthe point pretty well.
Tanous:/t certainly does. I guess it points out that among the activemanagers, some are going to be lousy and some are going to be good.But in the end, if the market’s return is 10%, then the aggregate ofthe passive managers and active managers must equal 10% beforecosts. Of course it must!
Sharpe: The active managers have to be better than average to be
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good enough to beat the passives. That’s because of costs [the feesthat active managers charge].
Tanous: Therefore, the name of our game is to try to identify thosepeople who either have been, are likely to be, or continue to be, in theupper bracket.
Sharpe: This is very preliminary but there’s some work that I’vedone, that Marty Gruber has done, that Mark Carhart has done - he’san academic at USC who worked under Gene Fama and did his disser-tation in this area. He is doing some really nice work. What I get outof this work, and it needs a lot more investigation, suggests that fundsthat have done well - that have beaten their style benchmarks,meaning they’ve done well relative to what they do - have addedvalue.
Funds that have done well in that sense, in the relatively recentpast, meaning one, two, or three years, will be slightly more likely todo well next year than those that have done badly. A lot of this, ofcourse, is because the bad ones are the ones with high costs and highturnover. But if it were just that, you’d expect that the best performersin the past would still underperform the benchmarks. But there issome evidence that they don’t. They actually outperform them a little,net of costs, except loads. I’m leaving loads out. [A “load” is a feecharged to purchase a mutual fund.]
Mark’s work suggests that the funds that did well last period werethe ones that tended to pick stocks that had done well in the priorperiod. We know that stocks in the U.S., although not in every country,tend to have short term persistence. So if you buy stocks that outper-formed last year, they tend to do better in the near term. You tend todo okay if you keep buying the very recent winners. Mark’s work, ifI read it correctly, is suggesting that the funds that did well recentlywere doing that. To the extent that they keep doing it, they’ll outper-form.
On the other hand, Marty’s work, and mine also, suggests thatwhatever it is that makes a fund successful, has a relatively shorthalf-life. So you don’t want to buy the fund that did well five yearsago, but you may want to buy the one that did well last year. Thismay be because managers move on; or raise their salaries so highafter they’ve done well that all the benefit is gone; or a fund has toomuch money and can’t do it any more. [Funds that are very largebecome illiquid - their stock purchases move stock prices up; their
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stock sales move that stock’s price down just because they are so big.]Could be any or all of the above.
We're learning more about this process. But, it remains true thatit’s really hard to beat a passive strategy with active managers, al-though we see some evidence of people who do it. | work with somepension funds that manage to get managers who on average, moreoften than not, collectively beat an appropriate set of benchmarks. Iwon't say all the funds I work with do! And I won’t tell you whichones are which!
Tanous: When you refer to the persistence of positive-style adjustedreturns, are you talking about very style-specific managers, who tendto stick to the four corners of the stylebox? [A stylebox is a chartwhich shows how true a manager’s portfolio is to his stated style.Managers whose portfolios are in the corners are consistent with theirrespective styles. The corners are value, growth, large and small.]
Sharpe: People have told me that the ones who seem to win, relativeto style, tend to be fairly consistent in their style BUT, I’ve never donethat analysis directly myself and I haven’t seen any papers on it.
Tanous:Let’s talk about value stocks and growth stocks. Isn’t itwidely acknowledged today that value stocks outperform growth stocksover time?
Sharpe: That’s not widely acknowledged! A number of us havefound that, in various places, value stocks have outperformed growthstocks over time. The issue of whether or not they will in the futureis still very much debatable.
Tanous:But is the statement true historically? Value stocks haveoutperformed growth stocks?
Sharpe: That obviously depends on where you are and what thetime period is. Nothing is universal in this world of investments. Butthe work Fama and French have done, the work I’ve done on othercountries and what Fama and French have now done on other coun-tries, the results people have found in various models over the years,seem to indicate that over the long term, that it has been the case.Again, there’s still a lot of dispute on how persistent this is and, ifit’s going to occur, why it’s going to occur and all the rest. It’s notuncontroversial.
Tanous: Yet so many people believe that the case for value stockperformance is rock solid.
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Sharpe: Some people will tell you, oh yeah, it’s proven. But it’snot.
Tanous:The question I’m leading to is, if you accept that valuestocks, under whatever conditions, outperform growth stocks, manyof the passive theorists claim that the reason they do is that valuestocks are riskier. Is that true?
Sharpe: They’re not riskier historically, with the possible exceptionof the ’29 and ’30 period in the U.S. There is some work, althoughit’s never been published, that suggests that so-called value stocks,low price-to-book stocks they are also called, took a real bath in the’29-’30 period, but for virtually any other period when the studieshave been done (except maybe in Switzerland), you find that theyhave lower standard deviations; they have lower betas. The Fama-French position is this kind of bizarre metaphysic that says: “valuestocks do better; but we know in an efficient market things that dobetter ought to, in some sense, be riskier, ergo, value stocks are riskier!Now we don’t happen to have seen the manifestation of the risk[laughter all around], but it must be so, therefore the market is effi-cient.” End of discussion.
Tanous:So are you saying that you don’t think that value or distressstocks, are, in fact, riskier than growth stocks?
Sharpe: This might be what we generically call a peso problem.You get something that has a very small probability of a real disaster;you can look at 20, 30, 40 years and never see the manifestation ofthe disaster [because the probability is so small]. As a result, youwon’t see evidence of the risk, but it’s still there. A lot of people say,well, if value stocks have done better it’s because when you buy valuestocks, you take this gamble: There is a small probability of a totalwipeout. For the last fifty years people who have taken that gamblehave gotten lucky. If you say that, there is no way to test that theory.
Tanous:But that statement is intellectually very unsatisfying.
Sharpe: Absolutely. Jeremy Grantham, a money manager in Boston,did some work which I believe shows that if you owned low price-to-book stocks [value stocks] in 1929 you would have had to wait until1939 before you were made whole.
Tanous:The study we saw is the Lakonishok, Shleifer and Vishnywork [“Contrarian Investment, Extrapolation, and Risk,” The Journalof Finance,vol. XLIX, No. 5, December 1994].
Sharpe: Yes. That shows value stocks doing better, without a
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manifestation of higher risk. That’s post-war. There are various studiesout there, but the only one I’ve seen or heard of that seems to showsome evidence of a risk that goes with value stocks is JeremyGrantham’s.
Tanous: Interesting. Put your investor hat on. Faced with all of thisdata, wouldn’t you want to own a lot of value stocks?
Sharpe: Well, probably not if I were paying taxes on it. Valuestocks have high dividend yields. Some of this may be just the taxeffect. In an economy where a fair number of people pay higher taxeson dividends than on capital gains, you’d expect that stocks that givemore of their return in tax disadvantaged ways, ie. high yield, i.e.value, would have to do better before tax to make them competitiveafter tax.
Tanous:Fair enough. But the vast majority of institutional stockbuyers, like pension funds, don’t have a tax problem.
Sharpe: What I would do is put the value stocks in my tax deferredaccount and the growth stocks in my other account. But I wouldn’tgo all value. I don’t go all value. I tilt toward value, but if I have todo it in taxable accounts, I don’t tilt a lot.
Tanous:A few minutes ago, you spoke about the persistence of re-turns with certain funds. There is a style of investing based on thattheory - momentum investing. I interviewed Richard Driehaus who isa proponent of that style. Richard and people like him believe theyare exploiting inefficiencies in the market through what they call“positive earnings surprises.”
Sharpe: Langdon Wheeler of Numeric Investors is another one. Hehas a remarkable record. He has capped that strategy and won’t takeany more money. There is evidence, and try as they might, the ac-countants and financial people can’t make it go away, that when youget an earnings surprise, somehow or other the market doesn’t seemto absorb it all right away.
Tanous:Exactly. It takes time. And for those who are on top of theinformation, that may present an advantage. Right?
Sharpe: It’s not hard to get the information. You have to worryabout liquidity, and have a good trading desk, and all that.
Tanous:But it can happen.
Sharpe: There have been a lot of studies of it and some people havedone well with that strategy.
Tanous:Are we poking holes in the efficient market theory here?
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Sharpe: Well, you’ll have to ask the accountants who study thatphenomenon