:But here again, the standard deviation of the small valuestrategy is lower than the standard deviation of the small growthstrategy [figure 2]. So, simplistically, that suggests that small valueis less risky, but still provides higher returns.
Sinquefield: I wouldn’t make much of that. The difference is notsignificant. Now these numbers, the standard deviation of the S&P500, at 15.6, and the standard deviation of the CRSP 6-10 [Small-Cap] index, at 24.2, are indeed significant. We also see the well-knownsize effect. Small value has much higher returns than large value,small market higher than big market; and small growth higher thanlarge growth. Incidentally, what makes us confident that this is a riskstory, and a story that is going to continue, is that when we go to anindependent arena, the international markets, we find portfolios thatare formed the same way as they are in the U.S. and have the samekinds of premium relative to the overall market.
Tanous:Could you demonstrate the value versus growth thes-is ?Sinquefield:: Look at this graph [figure 3]. This shows the returnon assets [1964-1992] for value and growth stocks. You can see thatthe return on assets for value stocks was pretty low compared to thereturn on assets for growth stocks. But for the same set of firms, thereturn on their stocks was very high for value stocks, and comparat-ively much lower for growth stocks. That’s the essence of the story.
245PETER J. TANOUS
Earnings Performance of Companies (Raturn on Ansats)¥5. their Stock Market Performance
 
Company Eamings va. Stock Market Returns
 
Rewm on assets Rate of retum (% per year)(% per year) 194 —19921964—199210.22 15.760 6$ “4 Message:6.46 8 10-45 * Smoll-cap€ w shocks8 and yaloe4 i © slocks have2 4 — hower felative2 earnings (han° 6 large-capvalue growth value growth socks andstocks stocks atocks stocks* Ther lower” 9.37 % 14.60 earnings“4 cause Wem to8 750 " 11-60 have higher10 ogsis of€ is 3 caphal and4 ‘ therotore,higher2 . : omecdead0 oOsmall large sivall largeStocks stocks stocks stoc
Courtesy: Dimensional Fund Advisors Inc., Fama & French.
Figure 3
Tanous:That’s quite convincing.
Sinquefield: That’s why it’s a cost of capital story, relating toearnings success or distress. What Fama and French did was tie allthis together and say that there is a rational market explanation forall these differences. That’s why it has gotten so much attention.
Tanous:Now may be a good time to explain the three-factor mod-el.Sinquefield: “The three-factor model” is the term we use in contrastwith the “one-factor model.” The one factor model is, of course, the
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famous capital asset pricing model [CAPM] developed by Bill Sharpe[page 89], Jan Mossin, and John Lintner. This is the concept for whichBill Sharpe shared the Nobel Prize in 1990 with Merton Miller andHarry Markowitz. In fact, Sharpe’s work was a direct offspring ofHarry Markowitz’. Sharp produced this very simple model that asked,under certain assumptions, how are securities priced in the market-place? So it was called CAPM, the capital asset pricing model.
What Sharpe basically said was that, the return on a security or aportfolio - makes no difference - is directly related to the volatilityof that security or portfolio relative to the market. [Remember thatthe market has a beta of one. So if a stock, for example, has a betaless than one, that stock is less volatile than the market. A numberhigher than one means that it is more volatile than the market.] Tooversimplify, the CAPM model concluded that higher volatility, orbeta, constituted higher risk, and that is what an investor expectedto be rewarded for. The market is the one factor that drives the returnon securities. If a portfolio has the same relative variation/ volatility,or beta, as the market, it’s going to have the same expected return.If the beta is higher, then the portfolio has got more variation/volat-ility and it’s going to have higher returns. Unfortunately, the theorydidn’t work. Over time, it suffered from empirical onslaughts, but itwas an absolutely invaluable tool. Academic work in the field wouldnot have advanced without that model. It was developed in 1964.Much of the early efficient market work used that model.
Tanous:! suppose that leads us to the three-factor model.
Sinquefield: The CAPM model said that you would get more thanthe market return in your portfolio if your beta is greater than one.If your beta is less than one, your expected return was less than themarket because you chose to take less than market risk. This was anelegant theory, but in practice it didn’t always work. The alpha [ameasure of return in excess of market return] was a measure of returnsthat you got over and above that due to risk-bearing. This is whatwas used to measure the performance of portfolios. This model wasvery important academically and professionally, for a long time. But,as I said, it eventually gave way to the three-factor model.
The three-factor model, and the CAPM, which is a one factormodel, have a common factor, the market factor. But the three-factormodel has the two additional factors, the size factor and the valuefactor, hence the three-factor model. As a result, this model allows
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us to measure the sensitivity of whatever portfolio we’re testing tothe size factor and the value factor, in addition to the market factorwhich was the single factor in the CAPM model. So, if I have a port-folio that is marketlike, I have a beta of one [one representing themarket]. When all these factors are present, the betas on nearly alldiversified equity portfolios become one. They all have about thesame amount of exposure to market risk, which is a new finding. Butthese diverse portfolios will differ from one another by their exposureto the other risks, value and size, and the three-factor model is themethod by which we can evaluate that additional risk.
Tanous: You say that the value and size risks may be greater, butat the end of the day, that has to be reflected in the market risk,doesn’t it?
Sinquefield: No. The reason that these betas differed from one inthe old model was that the value and size factors were excluded. Sothe risk that they were contributing to the portfolio looked like addi-tional market risk, but the fact is that the real causes of the variationwere the size and value dimensions. Do you want to see where variousindexes fall on the style map? Look at figure 4. Are the indexesgrowth, are they value, are they big, are they small? Anything to theleft of the vertical dividing line is growth, anything to the right isvalue. Anything below the horizontal is large and anything above itis small. [The hash marks measure the sensitivity of an index tovalue/growth along the horizontal axis and to large/small on the ver-tical axis.]
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A Style Map of Popular indexesBased on Data for Janvary 1979—December 1995Small-Cap
PBarrarows w
 
Courtesy: Dimensional Fund Advisors Inc.
Figure 4
Now look at the overall market portfolio at the crosshairs. Thistefers to all ten size groups we use. The S&P 500 is down here [belowthe crosshairs]. So you see that the S&P 500 is neutral on value andgrowth [it’s right on the vertical line] but it is biased away from smallcompanies and toward larger companies, so it’s going to have returnsslightly lower than the market due to the underweighting of smallstocks. But look at some value indexes like the Wilshire Large Valueindex. It’s off to the right, and down a bit, because it’s biased toward
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large companies. But it’s much more value-oriented than the S&P500.
In terms of expected returns, based on years of data, each hashmarkthat we move to the right or the left is worth about 50 basis points ayear in expected return difference. Along the size dimension, eachhashmark up or down the chart is worth about forty basis points. Soif you’re moving on a 45 degree line up the page, you’re picking upboth size expected return and value expected return.
Tanous:In other words by heading toward small-cap value...
Sinquefield: You're picking up a lot of expected return, but you'realso picking up a lot of extra risk. You’re adding size risk. If you havea portfolio comprised of small companies that have high book-to-market ratios [low price-to-book ratios], the chart tells you that you'vegot a lot of size risk, and a lot of value risk, in addition to one fullscoop of market risk. And, because you’re taking those three types ofrisk, you should have above market expected returns.
Tanous:So basically, there is no free lunch.
Sinquefield: No free lunch at all. That’s the essence. There are waysto get higher returns and lower returns but they all come at a price.
Tanous:I was hoping that the graph you showed me [figure 4] in-dicated that the market risk was the same for small-caps as for themarket, even though smail-caps had higher returns than the market.I guess that’s not what it said.
Sinquefield: It does. If you invest in small-caps, you’re taking asmuch market risk as someone who buys the S&P 500, but you’re alsoadding a lot of size risk.
Tanous:Let’s talk about your firm. Say I’m a potential client. Allthis sounds interesting in an academic sort of way. But how does this,or you, help me make money?Sinquefield: The thrust of DimensionalFund Advisors is to take what we believe is the best theoretical andempirical work that the academic world has produced and turn theseinto products that are useful for our institutional investors and ad-visors. The various specialized asset class portfolios are meant to beused only by professionals. The reason we don’t sell to the generalmarket is because these products should say: “to be used under adultsupervision only.” We have intentionally made them rather strong,high octane. They’re also designed with all the other pieces in mind.So they are designed to fit together. You can combine them inINVESTMENT GURUS
whatever proportions you want, based on how much risk you wantto take. That’s the general thrust.
We've created about sixteen different asset class portfolios aroundthe world, along the dimensions of size and value. We have domesticlarge value, domestic small, international large value, internationalsmall, etc. Some have regional modules.
Most of our clients are institutional and come to us for particularasset classes rather than to run their whole fund. But some clients dogive us all their money. Fee-only advisors typically use us for all oftheir clients’ assets. Were you to ask us how to go about runningbalanced portfolios, we would say that, if you’re going after abovemarket expected returns, then here’s how we would do it. Parenthet-ically, let me add that, if you’re going after market returns, it’s verysimple. You can hold an equity index fund and a short-term fixedincome fund, and that'll do fine. That simple 60/40 portfolio comparesrather favorably to all of the balanced funds in existence since 1976.It beats more than half of them. As simple as it is, it really works.
But, suppose somebody says, I want to go for above market returns,how do I do it? Okay, the only way to accomplish this reliably is totake additional risk. Based on the research, we know the avenues togo down to get that risk. They are the value avenue and the size av-enue. We’re going to do that domestically and internationally. Theequity portion of the portfolio would be split something like this: Wewould put about 30% of the equities in the international markets,70% domestically. The domestic would be roughly 40% large-cap and30% small-cap; the large would be split equally between growth andvalue; the small would be split the same way [equally between growthand value]. The international arena is similar, except that we wouldnot hold a plain market portfolio, like an EAFE fan index of interna-tional stock markets] fund, internationally. There seems to be no be-nefit to U.S. investors by doing that. Instead, we would split our alloc-ation between value stocks and small stocks internationally as well.
Tanous:To wrap it up, here we are ina world of thousands of mu-tual funds, all competing for investor attention, all touting extraordi-nary records. Go through Forbes, Money, Worth, see page after pageof marvelous records - 28% per year...32% per year...18% per year.All these geniuses making extravagant claims in an attempt to getour money so that we can enjoy these wonderful results for the nextten years, like those who got rich over the past ten years. Now, I'm
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sitting here with you, looking out your window at the Pacific Ocean,and you're telling me that it is all bogus. If you really want to makemoney in the market, you might say, don’t try to beat the market, jointhe market. Is that fair?
Sinquefield: I’m saying that you’re only going to get paid for risk-bearing. You can expose yourself to various asset classes that varyin their risk, and that’s what you’re going to get paid for. If marketswork, that’s all you’re going to get paid for. The reason we see allthese people advertising these fabulous records is that the only oneswho can afford advertising are those who have had fabulous records.You would be a fool to go out and say, “hire me, I’m the worst man-ager in past ten years.” Equity returns are inherently variable, so therewill inevitably be a wide range of returns, even among highly diver-sified portfolios. That’s why we can get some people advertising fab-ulous numbers. We also know that there are people at the other endof the spectrum, none of whom choose to spend advertising dollarsright now. They have nothing to sell.
Having left Rex’s posh offices in beautiful Santa Monica, I couldn’thelp but realize that this interview wasn’t exactly easygoing, and forthat I apologize. Nevertheless, we are dealing in some really importantconcepts that we have to try to get a handle on.
The notion of risk in the market is important. Bill Sharpe, et al.,won a Nobel Prize in economics for their work on the CAPM model,which introduced beta as a measure of volatility, as well as otherways of measuring risk important to the financial world. In the three-factor model, that approach is refined. It says that market risk is justone kind of risk. There are other risks. One is style - that is, valueversus growth stocks. The other is the size component - that is, smallcompanies are riskier than large companies.
So what? You might say. Well, isn’t it nice to know that in puttingtogether a portfolio you are able to determine with reasonable accuracythe kind of risk you are taking, based on the kind of stocks you areselecting for your portfolio? It does make sense, and it is importantto have some knowledge of these principles which are at the cuttingedge of our ever-growing knowledge about investments in stocks.
As to Rex’s position on market efficiency, his position is as dogmaticas it gets. He believes markets are efficient. Period. He allows littleroom for individuals who can predictably outperform the markets overtime, claiming, as he does, that these “outliers” are only identifiable
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after-the-fact, or ex post facto. In other words, the battle lines aredrawn. As we hear other voices and engage other discussions, we willhave an opportunity to judge for ourselves who is right and wrong onthis important subject. Our opinions should and will influence ourattitude toward stock market investments from now on.JOHN BALLEN
John Ballen has managed the MFS (Massachusetts Financial Ser-vices) Emerging Growth Fund since 1986. To look at him, you mightguess that MFS, the institution which gave birth to the mutual fundback in 1924, had decided to entrust him with this responsibilitywhile John was a sophomore or junior in college. That wouldn’t betotally accurate, but you might want to ask to see his driver’s licenseanyway. Ballen ascended to Guruhood in the simplest manner possible- he outperformed his peers over a very long time. Indeed, his MFSEmerging Growth Fund has achieved a growth record of 30.5% a yearfor the five years ended 1995 and 20.3% for the ten-year period. Anyquestions?
This young man is not your ordinary portfolio manager. A graduateof Harvard, with an MBA from Stanford, his first love was academia.Strange that this fellow, who has consistently beaten the market bya wide margin, might have joined the bastion of academics who claimthat people like him barely exist. In this interview, we examine hisviews on the active versus passive controversy and delve into the cri-teria that contributed to his extraordinary success as an investor.
This interview took place in MFS’ offices on Boylston Street inBoston. Not once did Ballen feel compelled to leave the room or beinterrupted by the market, which was roaring ahead the day we met.
Tanous:How did you first get interested in stocks?
Ballen: I didn’t really have a background in the stock market. Myparents came from pretty modest backgrounds. My father is a lawyer,my mother a school teacher. | became interested in the markets inbusiness school. At the time the job of analyzing stocks seemed likesomething I might be good at. I had an academic bent myself and Ihad almost pursued a Ph.D. program [Ballen was accepted in the Ph.D.program at Harvard.] | had won a Fulbright scholarship, and com-pleted a master’s in economics. But, analyzing stocks seemed like apretty thoughtful business, in which you could be creative, and maybethink a little ahead of the next person. So, it was a combination of acareer that looked pretty interesting and something I might be goodat. Besides, there was a pretty good investment management programat Stanford at the time.INVESTMENT GURUS
Tanous:You did some other interesting things. It certainly lookslike you didn’t have to worry about what your “safety schools” werewhen you were applying to college. You went to Harvard for yourbachelor’s degree and got your MBA at Stanford. What in the worldpossessed you to continue your education in Australia?
Ballen: I wasn’t sure what I was going to do in life and I was inter-ested in academics. A Fulbright is a very academic thing to do andthe Fulbright got me to Australia. There was no specific reason, otherthan that it seemed like a fun place to go and spend a year.
Tanous:John, your investment record is phenomenal. You’ve beenmanaging the MFS Emerging Growth Fund for almost ten years now.According to my records, over the last five years your compoundedannual return has been over 30%, and over 20% over the past tenyears. As you know, this book focuses on methodology and process,which is a fancy way of saying, how do you do it? Let’s talk aboutyour process of selecting stocks - what you look for.
Ballen: For us, making sure we are early in the process is key. Thatmakes ours a very research-intensive process. Wall Street is good atrecommending things that have done well, but not necessarily goodat recommending things that will do well. We do our own researchand, hopefully, get into situations before they are all played out. Wetend to stick to growth-oriented situations. We don’t want to be de-pendent on cycles that go in and out of favor. We want to find com-panies that will grow. Eventually, size attracts other people. If youbuy a small company that grows to become a large company, it getsrecognized by others.
Part of the investment picture is that you want to be right, but youneed other people to follow you fairly quickly. You don’t want to betight and be proven right ten years later, when it’s too late. In theinvestment process, you don’t want to be too early, and you don’twant to be too late. You want to be just on time. Given that you'relooking at growth companies, eventually companies that get largerget recognized. If they don’t get recognized by everybody, they getbought out by larger companies. I try to find companies - sometimesI say “I” but in the mutual fund sense we normally say “we,” so I canjust use them interchangeably - anyway, I look for companies thathave a competitive advantage in the marketplace. Going back to someof the academic examples, there are different strategies that companiescan follow - there’s a low cost strategy; a high-value-added strategy;
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and we also try to find companies that can carve out a competitiveadvantage and go for the longer term. If you look at some represent-ative aspects of that strategy, you'll notice that our fund’s turnoveris very low.
Tanous:! noticed that your turnover is under 40%, which is unusu-ally low for a small-cap growth strategy.
Ballen: Actually, our turnover was 20% in 1995.
Tanous: Yet yours is a high variance strategy, and your standarddeviation is quite high compared to the market as a whole. I wasfascinated that the turnover was so low, given this strategy. I stillhave trouble reconciling that.
Ballen: Well, the positive to the turnover is, if you’re a taxable in-vestor, your after-tax returns are much higher. | think we’re eitherthe highest returning fund, or the second highest returning fund, onan after-tax basis over a ten-year period. But you asked why theturnover is so low. Well, one reason is the longer-term focus. We tryto find companies that we want to own for the long term. If we findthose companies, we stick with them. If you look at the top holdingsin the fund, there are companies that we’ve owned for as long as fiveto ten years.
Tanous:Please name a few.
Ballen: HFS is the largest holding. [HFS is a motel franchiser.] Webought that company on the initial public offering in December of1992. By the way, a lot of people ask, why do you buy initial publicofferings? Is it just for the initial pop? HFS was a six million sharedeal. As a firm we got one hundred thousand shares on the offering.It went up two bucks - 16 to 18 - so we made two hundred thousanddollars. We then bought a million and a half shares in the after-mar-ket. In the ensuing four years, that stock has gone from 18 to 180.So, yeah, we made $200,000 on the IPO, and we made $250 millionto $300 million since. That’s the reason for trying to be early, forseeking out some of these companies as soon as they come out. HFSwent up ten times in three years and we’ve held it since then.
Our second biggest holding is Oracle Systems. It has its ups anddowns, but the initial position, when we bought the bulk of the stock,was one dollar a share on an adjusted basis. This was back in 1990.The company grew tremendously for five or six years. The stock hadgone from 3 to 35, something like that, and it hit the wall - bad ac-counting, aged receivables, and so forth. We went in, looked at the
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technology, looked at the company, and basically made the decisionthat they were going to survive and, after a transition, do well on theother side. We’ve pretty much stuck with the stock since the time webought it. The stock is about 40 today. We continue to own it.
Our third largest holding - let’s see - that’s probably UnitedHealthcare. We’ve owned United Healthcare since 1988, and we’veadded to it at various times. They are the leader in health maintenanceorganizations. We have believed that cost containment is very import-ant to the future of health care, and that HMOs are going to be theway that the government, corporations, and individuals are going toachieve it. The managed process is going to win. We stuck with thesecompanies in good times and bad. There’s a good example. UnitedHealthcare has had a lot of volatility, as has Oracle. If you believe inthe long term and stick with a position, that adds to your short termvolatility.
Of course, if we were smart enough to get in and out of the stocksat the right time that would help, but I’m not sure we’re smart enoughto do that. You see, sticking with the companies as they go up anddown contributes to higher volatility in the portfolio, but if you pickthe right companies, you get the returns.
Tanous:Just hearing about those three stocks makes me want toget right back to the question of process. We’re talking about prettydifferent types of companies. Health care, technology, lodging, yetyou've picked stocks from all of these industries, right? You said thatyou're looking for early stages of growth, but that’s the investmentequivalent of motherhood and apple pie. Everybody wants that andnobody will disagree with that approach. Yet the fact is that you areunusually successful at finding the early stages of growth. So I wantto delve a little bit more into what John Ballen looks for in a healthcare company, in a high tech company, in a lodging company, andsee if we can identify what he finds that others don’t.
Ballen: In all three of those companies, and I haven’t really thoughtabout this until you asked that question, there is a similarity. If youlook at the business model of all three of those companies, | thinkyou'll understand what attracts me to them. HFS is a franchiser, theydon’t own any real estate. They get a four percent royalty fromHoward Johnson’s, Ramada, Super 8, and from other lodging brands.And they are, basically, not using any of their own capital. It’s a su-perior business model, if you can grow it, because it doesn’t require
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a lot of capital and it throws off great cash flow. That’s an almostinfinite return on equity. The same thing can be said of UnitedHealthcare. They don’t own any hospitals, they don’t have any capitalinvested - an infinite return on equity. It’s basically a marketing ma-chine with networks and information, and so is HFS. They are notasset-intensive businesses at all. The third one, Oracle Systems, is thesame story. It’s not a hardware company, it’s a software company.There’s no capital employed so there is an infinite return on equity.You're leveraging off the brand name equity. All three of these stocks,which have been tremendous investments in the market, have thatsimilarity. Their business model is not flawed.
Why do I do it this way? I guess the story I would tell is this: Therewere two companies that started about the same time in technology.I think people would have argued that both these companies wouldbe really successful back in the mid-’80s. The two companies wereMicrosoft and Sun Microsystems. Sun was going to lead in worksta-tions and was going to make the next generation PC, while Microsoftwas going to become the leader on the software side. Now whathappened is that both companies have grown to about the same size.They both grew to $4 billion, $5 billion, $6 billion fin revenues]. ButMicrosoft has been a much better stock. The reason is that Sun is ina capital-intensive business with much lower return on equity, or re-turn on capital, and the return to the investor has been much less. Sowhile there is a place for investing in capital-intensive businesses, ifyou really look at the great stocks in the last ten or twenty years,they have been those companies that have been able to leveragethemselves successfully.
Tanous:That’s very interesting. So one of the things you look foris a franchise, in the broad sense, which you identified as the businessplan, and a system that almost has cookie cutter applications. If yourun one hotel or hospital successfully, if you do one right, chancesare you're going to do the others right. Is that it?
Ballen: That’s for sure. In all these ideas, you want to make surethey are expandable. The franchise element is the most importantthing. You’re getting paid for something in addition to the capitalyou're putting up. It’s not so much a commodity-type business. Youcan go into commodity businesses, but you have to recognize it’s adifferent type of investment. You want to find a company that’s goingto become the largest company. It’s going to have the best economies
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of scale, the lowest costs. It’s a whole different business model. It re-quires access to capital as well. Obviously, if you have a lower returnon equity, you’re going to need to raise capital.
Tanous:How else might you characterize your selection criteria?
Ballen: I categorize the types of stocks I buy into four categories.(1) Growth at a reasonable price - that’s where the value guys andthe growth guys sort of agree. (2) The second-chance stocks - whereall the facts are on the table, but people choose to ignore them, andthere’s a turnaround coming - like Oracle Systems. HFS would be agrowth at a reasonable price example. (3) Traditional growth stocks- once you're in some of these stocks, you might be early, but if youfollow, as you said, a cookie cutter approach, they roll out the growthand you hang on for dear life and make ten times your money. Forexample, in the Office Depots of the world. (4) The non-traditionalgrowth stocks - sometimes the most opportunistic, like the HMOs andwhatnot. These are companies that are not perceived as excitingcompanies, but something is changing out there, and you are one ofthe first to recognize that something is different in the industry. HMOshave been around 30 years, but it’s only been in the last ten yearsthat the emphasis on cost changed the industry. This became an ex-citing growth industry even though it had not been before. Sevenyears ago a light bulb went off in Detroit that said, you’ve got tolower costs to compete with the Japanese. So, if you are clever enoughto buy auto part suppliers, and you figure out that the big companieshave to outsource and give business to these other firms, you succeed.If you can be early, a lot of times these companies are selling at verylow multiples with very little growth, and then they take off.
Tanous:Let’s take another example and again focus on methodology.Take Office Depot. When did you first buy that stock?
Ballen: We bought it around when it went public, in ’86 or ’87.We've owned it since. It’s gone through three separate periods. In thefirst period, there were four major companies in that field that wentpublic - BizMart, Office Depot, Office Club, and Staples. We actuallybought all four companies. We liked the industry; they all had about20 stores. At that point, you couldn’t tell who was going to be suc-cessful and who wasn’t; who was going to get the capital and whowasn’t. In this case, you really had to bet that the winning companieswere going to win enough to offset the losing companies.
Tanous:Did you have equal holdings in all four?
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Ballen: Initially, we probably did have fairly equal holdings in allfour. Over time we sorted them out; we learned more about them.Two