Notes, Views, and the Occasional Provocation January / February 2010 

Much of today's conventional wisdom about how to invest was developed over fifty years ago and persists despite compelling evidence that it hasn't worn well. The "safe" or "blue chip" stock lore is part of this legacy, and this month's newsletter highlights how dangerous it is to let a good story drive investment decisions.

Warm regards,

Milo Benningfield

What We Can Learn From Toyota
The narrative fallacy of "safe stocks." more

BFA Media Quotes
Recent media quotes. more

What We Can Learn From Toyota
After last year's historic stock-market rally, many investors are finally ready to dip their toes in the equity markets once again. January marked the first month in many that investors put more money in stock mutual funds than they took out.

But, of course, investors want to be "sensible" as they re-enter the markets. And thus the allure of "safe stocks" – aka, "blue chips" – calls once more to them. As SmartMoney notes, stock analysts expect investors to "shift their attention to strong, stable companies, particularly when events like Dubai's and Greece's debt scares remind them that the market's rally can come to a quick halt."1

The "safe stock" narrative is a familiar and comforting tale, one that routinely comes into vogue during times of market turbulence. But it's a false narrative, since there is no such thing as a "safe stock," especially when viewed in isolation.

Investors in the 1960's learned this hard lesson, when, fed up with the boom and bust in space-age stocks – companies with a penchant for putting "tronic" and "sonic" in their names (e.g., Videotronics, Circuitronics, and Powertron Ultrasonics) – they turned to "safer" conglomerates. When those acquisition machines – companies like Teledyne and Litton – failed to live up to their promise, investors looked for yet another safe bet. As William Bernstein notes in his book, The Four Pillars of Investing:

[B]y 1970, investors had had it. They were fed up with flaky tech companies and corporate investors who could wheel and deal with the best but who couldn't operate a profitable company if their lives depended on it. They wanted safety, stability, and excellence – established companies that dominated their industry and had the proven ability to generate genuine growth.

Thus was born the "one-decision stock": buy it, forget about it, and hold on to it forever. So investors loaded up on the bluest of the blue chips – IBM, Xerox, Avon, Texas Instruments, Polaroid – great companies all, at least in the early 1970s.2

The so-called "Nifty Fifty" stocks flew high for a while. Then most of them lost 70% to 95% of their value during the mighty bear market of 1973-74, many of them never recovering from the declines.

The legend of the "safe stock" should have died along with the Nifty Fifty. But it did not, for one simple reason: we love a good story. Here's William Bernstein again, this time from his more recent book, The Investor's Manifesto:

Psychologists and historians have long known that humans are hardwired to understand events in narrative form; man truly is the primate who tells stories. When a problem becomes too logically or mathematically complex to grasp easily, humans default back into this evolutionarily ancient story-telling mode. The trouble is that in finance, things can get complex in a hurry.3

This penchant for stories leads to what the behavioral economists call "narrative bias" – a tendency to obscure important facts that don't fit within the preconceived story line.

For a while, the longest running story on Wall Street was General Electric Company. Competing against the rise of mutual funds in the 1980s and 90s, stockbrokers sold GE to investors as the ""most diversified mutual fund in the world." After all, GE subsidiaries were involved in everything from finance to media to manufacturing.

The company had a charismatic leader Jack Welch whom Fortune and Forbes enshrined as the preeminent example of managerial excellence. And GE cemented its reputation as a reliable holding for conservative investors' portfolios by meeting or beating stock analysts' earnings estimates every single quarter from 1995 to 2004.

Then the mist evaporated. We learned that GE had been using sleight of hand for years with its finance division GE Capital to meet those earnings estimates. In fact, GE could reasonably be characterized as, in essence, a bank with some manufacturing divisions attached to it – a far cry from "safe." During the recent bear market, the stock failed to offer any protection at all to investors, falling 80% in one year to below $6 a share by March 2009. A few months later, GE lost its AAA credit rating, and the SEC added insult to injury by fining GE $50 million for its accounting misdeeds.4

Of course, it doesn't take financial shenanigans to bring down a "safe" stock. We need look no further than the recent example of Toyota to see this. A few weeks ago, the world learned that Toyota has apparently been letting cars out the door with faulty accelerators and faulty brakes – on their premium brands, moreover, the Lexus and the Prius. There are numerous reports of tragic deaths caused by these defects, and the company's stock fell more than 20% after the disclosures.

Toyota's troubles show just how fast any company's fortunes can change. Before last month, Toyota was arguably one of the safest investment bets in today's turbulent world. Using just-in-time manufacturing processes and the philosophy of kaizen – always seeking continuous improvement – the company overtook GM in 2008 to become the largest auto manufacturer in the world.

Two years ago this week, The New York Times Magazine bestowed upon Toyota one of the most laudatory articles ever written about a company. In "From 0 to 60 to World Domination," we learned how the company had become a source of fascination for even bellwethers such as Microsoft:

Whether Toyota has evolved into the world's most sophisticated modern corporation – one whose example has challenged the American model of manufacturing and management – happens to be a common topic of conversation among business analysts these days. "It's influencing just about every major company in the world, in that they're asking the question: What can we learn from Toyota? says Jeff Liker, an engineering professor at the University of Michigan who has written several books on the company. Indeed, what you can learn from Toyota is something that even Bill Gates has pondered publicly.5

Today The New York Times coverage is much different:

Once a leading symbol of Japan's rise to global economic might, Toyota has become one of the most visible signs of its decline. And even before the recalls, Japan's rivals from South Korea and China had started overtaking Japan in key industries from semiconductors to flat-panel televisions. And Toyota on Tuesday issued another damaging recall, this time of its popular Prius hybrid.

"At this rate, Japan will sink into the sea," said Masatomo Tanaka, a professor of the Institute of Technologists, a university that specializes in training engineers. "If Toyota is not healthy, then Japan is not healthy."6

The Wall Street Journal has piled on, too, with articles reflecting the changed Toyota narrative:

  • "A Crisis Made in Japan," Wall Street Journal, February 5, 2010. ("Toyota's botched response to its escalating problems has deep roots in Japan's legal system and corporate tradition.")
  • "Kaizen Goes Kaput," Wall Street Journal, February 11, 2010 ("Toyota pioneered 'continual incremental improvement,' but then focused on improving the wrong things.")

Perhaps the media is once more pandering to readers' tastes, especially since in many instances Toyota is being criticized today for the very qualities that were praised before. But it's also likely that the new, more critical narrative forming around Toyota results as much from our need to explain the previously inconceivable: how could the world's paragon of manufacturing excellence suffer such humiliating and devastating product defects?

The problem with all such stories is that the quest for a satisfactory narrative line – something with a beginning, middle, and end; protagonists and antagonists; simple cause and effect – will obscure true understanding of a far more complex situation. We may feel comforted by the story that results, but we'll be left as much in the dark as ever.

Let's hope that Toyota can solve the mystery quickly and resume its mission to "enrich society through the building of cars and trucks."7 But it's time to put the safe-stock story to bed. There are no stocks – and, for that matter, no industry sectors, and no markets that are safe in isolation. Only within the context of a globally diversified portfolio, preferably one holding thousands of securities, not just a handful or even a few hundred, do the varying risks of different types of financial assets start to make sense.

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BFA Media Quotes

Wall Street Journal, January 14, 2010
Milo was quoted in Brett Arend's article "A Financial Plan For the Newly Rehired," which offers tips on how people can get their finances back on track after a period of unemployment. Milo emphasized the importance of rebuilding emergency funds that were likely depleted while unemployed: "'While it may be tempting to throw as much money as possible at credit-card and other debt,' says Milo Benningfield, a financial planner in San Francisco, 'it's usually better to strike a balance between paying down debt and accumulating new cash.'" Read the article.

Reuters, January 7, 2010
Milo was quoted in Clare Baldwin's article, "Lending to Family, Friends Can Be Fruitful," which offers some counterexamples to the conventional wisdom that making loans to friends and family members is bad business. Milo noted that while borrowers often turn to friends and family if they are not considered "qualified borrowers" by professional lenders, relationship-based deals can work to a lender's advantage. "'If you borrow from your parents or from a friend, preserving that relationship is very important. Unless you lend money to a psychopath, most people will really want to work hard to pay you back somehow, some way, and that's a huge piece of protection,' Benningfield said." Read the article.

Thank you for reading. Please look for our next newsletter in April.

Best regards,

Milo Benningfield

1 "Polishing Your Portfolio," SmartMoney, February 2010, p. 13.

2 William Bernstein, The Four Pillars of Investing: Lessons for Building a Winning Portfolio (New York: McGraw-Hill, 2002), 150.

3 William Bernstein, The Investor's Manifesto: Preparing for Prosperity, Armageddon, and Everything In Between, (New York: Wiley, 2010), 101.

4 "SEC Fines GE $50 Million for Accounting Misdeeds," BusinessWeek, August 4, 2009

5 "From 0 to 60 to World Domination," The New York Times Magazine, February 18, 2007.

6 "In Toyota Mess, Lesson for Japan," The New York Times, February 9, 2010.

7 "From 0 to 60 to World Domination," The New York Times Magazine, February 18, 2007.

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