Today’s Chapter is based on the book “Capital: The Story of Long-Term Investment Excellence” by Charles D. Ellis.
Capital Group Companies, founded in Los Angeles in 1931 by Jonathan Bell Lovelace, is one of the world’s oldest and largest privately held investment management firms, with over $3 trillion in assets under management. Best known for its American Funds family of mutual funds, the firm emphasizes active, research-driven, long-term investing and serves individual and institutional clients globally through more than 30 offices.
Here’s what I learned:
The People
“Four Seasons is the sum of its people—many, many good people.”
— Isadore Sharp
Capital Group has always understood that its true business was not just merely managing its clients’ money, but to cultivate the people who make the critical decisions within the company. From the earliest days under the leadership of its founder Jonathan Bell Lovelace, the organization treated the attraction, development and retention of exceptional talent as their unique competitive advantage. This philosophy remains visible today in every layer of the firm’s culture.
As a matter of fact, Jonathan Bell Lovelace and his son Jon repeatedly demonstrated leadership in reaching out to bring exceptional people to Capital, creating a flywheel effect where great talents attracted others to join the company. As Charles D. Ellis notes, “By their persistent searching for strong people—repetitively taking the initiative to exploit “lucky” opportunities—they assembled a collection of talented professionals who worked well together. Capital became increasingly recognizable as a firm of unusually capable and congenial professional people: a good group to join.”
“Capital is not so much in the investment business as it is in the business of developing individuals and groups who can and will make superior investment decisions and deliver superior service to clients. At this, it excels.”
— Charles D. Ellis
As such, it is not surprising that Capital Group’s hiring formula was spelled out with unusual clarity. Capital Group understood that attracting and keeping highly motivated and talented individuals is essential in building a superior professional firm. It noted five elements that guided hiring decisions, compensation designs and the interactions that defined the company’s character.
(1) Persistent and imaginative recruiting;
(2) Consistently high standards for acceptance into the group;
(3) Uncompromising search for meritocracy in the distribution of rewards and responsibilities according to real contribution;
(4) Devotion to professional excellence and superior service to clients;
(5) Genuine Collegiality;
Furthermore, even in moments of downturn, Capital Group refused to abandon this people-first approach. In fact, during bear markets where peers cut staff, the company continued to hire hundreds of new associates, including senior professionals. In fact, they preferred to recruit during industry downturns, recognizing that these periods were the best opportunities to secure talent that would otherwise be unavailable.
“Capital always wants to recruit and add people during industry downturns, because that’s a ‘win’ for everybody: Capital gets some very good people; they’re leaving troubled firms, so their former employers often feel relieved to have them safely and well placed; and they come to a place that really wants them. It takes courage and long-term vision, but as a private firm with a strong financial position, Capital can budget reserves, at least philosophically, for this sort of initiative and invest in itself for the long term—just as it does for clients.”
— Charles D. Ellis
This reminds me of Alan Greenberg, the CEO of Bear Sterns, who also had a contrarian approach compared to his competitors when it came to hiring. While other companies would have hiring freeze during recessions, Greenberg believed it was the best time to hire talented people or as he calls them number one draft picks. He writes, “We are not panicking; we are not laying off people, but we are making a real effort to cut expenses. The other side of the coin is we have hired a large number of number one draft picks in the last few months. This is the time to hire good people. We have followed this policy in the past, and I am convinced that we will be proven correct once again.”
Similarly, Greenberg loved to hire people differently from his other competitors. He enjoyed hiring people with PSD degrees, meaning that they were poor, smart and had a deep desire to become rich. This was in total opposition to the norm of other investment banks who restricted themselves to only hire individuals with MBA degrees.
“Our first desire is to promote from within. If somebody with an MBA degree applies for a job, we will certainly not hold it against them, but we are really looking for people with PSD degrees. They built this firm and there are plenty around because our competition seems to be restricting themselves to MBA’s. If we are smart, we will end up with the future Cy Lewises, Gus Levys and Bunny Laskers. These men made their mark with a high school degree and a PSD. PSD stands for poor, smart and a deep desire to become rich.”
— Alan Greenberg
Being a contrarian in business is certainly a great way of finding a competitive edge over the competition. This is equally right in investing as from the famous saying of Warren Buffett: “Be fearful when others are greedy, and greedy when others are fearful.” However, while being a contrarian in itself isn’t hard — anyone can say the opposite of what crowd believes, you must also be right to have an advantageous divergence in investing. This can be extremely hard. Not only that, timing is also an important factor for successful contrarian investing.
“Markets can remain irrational longer than you can remain solvent”
— John Maynard Keynes
Howard Marks, author of the book The Most Important Thing, is one of the most known contrarian investor. In his book, he coined the term “second-level” thinking as a way of having a contrarian view compared to the rest of the market who are first-level thinkers.
“First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favorable, meaning the stock will go up.” Second-level thinking is deep, complex and convoluted.”
— Howard Marks
The System
“A bad system will beat a good person every time.”
— W. Edwards Deming
Perhaps one of Capital Group’s most significant innovation is the multiple-counselor system it implemented for better portfolio management. This innovation actually emerged from a practical necessity. In fact, when Jonathan Bell Lovelace suffered a heart attack in 1953, the firm realized it had become dangerously dependent on a single visionary leader who controlled the entire decision-making process.
The multiple-counselor system divides a fund’s assets among several independently managed subportfolios, each overseen by a different portfolio counselor. This structure offers profound advantages that have enabled Capital to grow to enormous scale without sacrificing investment performance. As funds grow larger, they can simply be divided among additional counselors, each managing a comfortable-sized portfolio. The system also provides natural diversification across different investment styles, perspectives, and market approaches.
“Not only are portfolios diversified across many investments, they are also diversified across different styles and concepts of investing and across the several counselors’ differing perspectives on the market. Portfolio counselors are not individually responsible for achieving optimal overall portfolio diversification. An Investment Committee oversees the whole portfolio and coordinates the component subportfolios to ensure that all investments remain within the overall objectives of the fund.”
— Charles D. Ellis
Furthermore, the multiple-counselor system is a superior option to a pure group decisions-making system, which often produces compromises that dilutes the best ideas. Charles D. Ellis mentions that “Group decisions about investments were all too often compromises, the worst kind of decision-making in investing when interpersonal accommodation muddles creative thinking, rational decisions, and decisive action; and trying to forge a consensus from competing, even conflicting, differences of opinion resulted in social and mental exhaustion. Cross-sterilization was more likely than crossfertilization of insights and ideas. This is particularly harmful in investing where the best ideas are often tentative and ‘soft-shelled’ at their earliest, and potentially most profitable, stage.”
It is also a great tool for developing talent. This allowed analysts to begin managing real investments earlier in their careers, starting with small positions and gradually increasing in responsibility. This hands-on experience, combined with immediate feedback from senior portfolio managers, is invaluable.
“The multiple-counselor system encourages personal growth, particularly among research analysts, who manage real investments at Capital very early in their careers. An analyst typically begins investing in his or her own industry—one or two stocks at first, then more and more. Some analysts eventually manage very large amounts of money, all in the industries they know best. And there is no clearer or stronger professional and personal affirmation for an investment analyst, than to know portfolio managers are buying in size what the analyst has just recommended.”
— Charles D. Ellis
This story reminds me of Peter Kiewit who struggled with a life-threatening disease called phlebitis. As such, he came to realise that he could not do everything alone, and would need to delegate responsibilities to others. Kiewit explains that this was a game-changer: “If I had not had the illness, I might still be running a small, one-man show. What appeared at the time to be a misfortune actually caused me to depend on other people to carry on many phases of our work, and our present organization is the result.”
“A business dominated by one man, who makes all the decisions, who is reluctant to deputize responsibility lest his assistants make mistakes, lacks the elements of a permanent organization because it denies men the chance to grow and be ready for the larger responsibilities, which eventually someone must assume.”
— Peter Kiewit
Kiewit realised the benefit in having a management philosophy of decentralization. As a matter of fact, Kiewit developed a system of district offices where each managers had the complete authority in making decisions affecting their own operations. As such, district managers were responsible for bidding on projects, preparing estimates and to hire new employees. This allowed a major advantage considering that each local market opportunities are different and should be handled differently.
But more importantly, if one is to delegate, it is primordial to train employees in order for them to be ready for leadership roles. As such, Kiewit encouraged his employees to train and mentor a successor. He once said, “Before you can go on to a position of greater responsibility, someone must be trained to do your job, unless the job you are doing is not an essential one. If any of you fellows wants to admit that your job is not essential, you do not need to do anything about trying to see that anyone else is trained for your job.”
Furthermore, as Kiewit has always been a company that focused on their employees, Peter Kiewit mentioned that people and their talents are the company’s most valuable asset. As such, he preferred to promote from within rather than hiring from outside of the organisation.
“In some organizations, top jobs are reserved for relatives. I would like to say again that this is not the case in our company. It has always been our policy, and will continue to be our policy, to promote on the basis of their ability to perform. It has also been our policy to fill vacancies by advancing qualified [employees] whenever possible.
I’m happy to say that the number of occasions when we have had to bring [people] in from the outside for a particular job is negligible, and this should occur even less frequently in the future because of the fact that we are making headway in developing more and better [employees].”
— Peter Kiewit
The Long-Term
“Someone is sitting in the shade today because someone planted a tree a long time ago.”
— Warren Buffett
Another distinctive element of Capital Group’s philosophy is its genuine commitment to long-term thinking. As a matter of fact, the firm believes that the key to success is to balance the interests of its three constituencies: the clients, the associates and the owners. Charles D. Ellis writes, “Capital would not be managed to achieve either one or another of those three competing goals. Instead, it would be managed for the balanced achievement—as fully as possible and on a continuous basis—of reasonable objectives for three groups: 1. Clients 2. Associates 3. Owners”
By being a private firm, it was a lot easier for Capital Group to take on a long-term approach rather than needing to boost short-term profits for public shareholders. In fact, when Jonathan Bell Lovelace started Capital Group, he was quite skeptical of stock prices during periods of euphoria. As Charles D. Ellis mentions, “Capital conscientiously does what other organizations might find naïve or unrealistic: It concentrates on longterm value judgments and is persistently skeptical about short-term prices and popularity.”
As such, Jonathan Bell Lovelace insisted on investing after following thorough researches rather than following market fashion. He believed in investing in companies that traded below its intrinsic value. He used the “whole company” test to evaluate if he should buy shares at the implied valuation. Charles D. Ellis writes, “If you wouldn’t buy the whole company for that price, then you shouldn’t buy 100,000 shares, 1,000 shares, or 100 shares because you’d just be relying on a Greater Fool theory that somebody else is going to pay you even more for a piece of paper.”
“To determine the long-term worth of a company, JBL relied on thorough, original research into investment values that others might have overlooked—followed by purchases at reasonable market prices. Combining careful research with a long-term view on valuation, Capital’s portfolio turnover was and still is far below industry norms.”
— Charles D. Ellis
On the same line of thought, analysts and counselors were encouraged to think independently, taking a long-term approach when the crowd was moving in the opposite direction. As Lovelace once expressed, “It’s important to be accommodating. When everyone wants to sell, you accommodate them and buy. When everyone wants to buy, you accommodate them and sell. Don’t try to get the last 5 percent. Don’t be greedy.”
This does not mean that every unpopular investment is attractive. Contrarianism by itself is not an investment method. The point is that popularity and value are separate questions. An asset can be admired and overpriced while a neglected company can be disappointing and still too expensive. Independent thinking requires analysis, not merely opposition. In fact, a wonderful business purchased at an excessive price may produce mediocre returns. On the other hand, a troubled company may offer attractive returns if its valuation already reflects excessive pessimism. The key is the relationship between price and future value.
“Good companies are not always good investments and great companies are not always great investments.”
— Charles D. Ellis
This approach is eerily similar to Warren Buffett’s who is well-known for being the greatest investor of all-time. A big reason for Buffett’s success in investing is due to the fact that he had a great teacher and role model in Benjamin Graham, who is often named as the father of value investing.
According to Buffett, he took three main principles from Benjamin Graham’s investment philosophy:
A stock is the right to own a little piece of a business. A stock is worth a certain fraction of what you would be willing to pay for the whole business.
Use a margin of safety . Investing is built on estimates and uncertainty. A wide margin of safety ensures that the effects of good decisions are not wiped out by errors. The way to advance, above all, is by not retreating.
Mr. Market is your servant, not your master . Graham postulated a moody character called Mr. Market, who offers to buy and sell stocks every day, often at prices that don’t make sense. Mr. Market’s moods should not influence your view of price. However, from time to time he does offer the chance to buy low and sell high.
Firstly, Buffett recognises that stocks should be seen as a piece of business rather than a bunch of numbers on a screen. While the majority of people are speculators who are trading stocks as if they were chips in a casino, value investors such as Buffett try to identify the total value of the chips.
Secondly, Benjamin Graham mentions that value investors must have a margin of safety when investing, meaning that they must leave plenty of room for error. Buffett illustrates this concept of margin of safety with the following saying: “Buy one dollar for fifty cents.”
“You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying businesses. But you do not cut it close. That is what Ben Graham meant by having a margin of safety.You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin.”
— Warren Buffett
The reason why having a margin of safety is important is due to the fact that mistakes can be costly. In the case of investing, you must avoid losing money at all cost. As a matter of fact, “If someone has a dollar and she loses fifty cents, she has to double her money to make back what she’s lost. That’s difficult to do.”
On this subject, Buffett is known for this following saying: “Rule number one, don’t lose money. Rule number two, don’t forget rule number one. Rule number three, don’t go into debt.”
Finally, on the concept of “Mr. Market”, I’ll allow Buffett to explain it in his own words. In his 1987 Berkshire Hathaway letter to shareholders, he wrote the following:
“Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions, he will name a very low price, since he is terrified that you will unload your interest on him.
Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game. As they say in poker, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.”
Ben’s Mr. Market allegory may seem out-of-date in today’s investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising “Take two aspirins”?
The value of market esoterica to the consumer of investment advice is a different story. In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben’s Mr. Market concept firmly in mind.
Following Ben’s teachings, Charlie and I let our marketable equities tell us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it. As Ben said: “In the short run, the market is a voting machine but in the long run it is a weighing machine.” The speed at which a business’s success is recognized, furthermore, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.”
— Warren Buffett
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