A Study In Contrasting Styles

In Friday’s Wall Street Journal, E.B. Browning wrote a fascinating portrait of a fund manager at Neuberger Berman which contrasts starkly with a similar article written last year in which a reporter followed Warren Buffett around for a day. The look into the psyche of a "typical" portfolio manager vs one of the greatest investors of all time, is also important to understanding how and why markets do what they do.

Before I go and make fun of Jon Brorson, the Neuberger Berman fund manager profiled in the article, I want to praise him for allowing Browning to write a story about him.  Managing money is a lot like making sausage – it’s an ugly, confusing and sometimes complicated exercise that (hopefully) has a good end result.  To give a writer an unvarnished look at what a typical portfolio manager goes through takes some courage.  On top of that, Neuberger has had a decent track record since Brorson took over in 2002, so it’s difficult to say that his "style" doesn’t work.  It just seems to lead to a very painful existence. 

Brorson’s profile basically explains why sentiment analysis is as important to understanding the market as fundamental or technical analysis. I would guess that 40 – 50% of fund managers go through the exact same routine as Brorson, who’s self-flagellation and constant worry are pretty silly.  It’s this constant worry and focus on short term movement that eventually causes underperformance for the majority of funds. Every fund manager is beholden to an index.  When managers begin to underperform, they get nervous.  If they underperform long enough, they throw in the towel and join the "crowd."  And that is how tops and bottoms are formed. 

Perfectly rational and intelligent investors can make completely irrational decisions in the name of short-term gain. When managers like Brorson, who nervously punch up the leading stock sectors every hour because they are positioned incorrectly start acting on their worries and jump into the hot sectors, it’s time to take the other side of the trade.  These sentiment shifts by fund managers can show up in put/call ratios, Rydex sector data, and an increase in volume from speculative, low-quality stocks. 

Here are some excerpts from Brorson’s profile from Friday’s WSJ:

As the Dow Jones Industrial Average flirts with a record high, Jon Brorson is sitting at the base of what professional investors call "a wall of worry."

Mr. Brorson, a Chicago money manager with $2.3 billion under his supervision, is one of many doubters who stayed on the sidelines as the market marched ahead this summer. Now the Dow is up 9% in just over two months, within five points of its record closing high of 11722.98 after briefly crossing it yesterday. Investors like Mr. Brorson figure others are driving it too high, setting it up for a fall. They’ve been expecting a slowing economy to shrink corporate profits and lead to a pullback.

Mr. Brorson’s worries served him in May. Then, he shifted toward "defensive" companies whose sales tend to hold up in all kinds of economies, such as drug makers, food producers and electric utilities. His May move was gutsy — and right. The Dow got to within 81 points of its record and then fell 8% into July.

Now, as it rises, he’s fighting the trend again. Doing so keeps him up at night and, his wife says, makes him irritable. His travails over the past two months show just how hard it is even for dedicated pros to call the turns. It’s especially hard at times like these when investors are debating whether a shifting economy will change stocks’ direction.

"I am wiped out when I get home each day," says Mr. Brorson. He’s typically in bed by 9 p.m.

He attacks the workday, rising at 4:50 a.m. and, after showering and praying, riding a crowded double-decker train. To be one of the first off, he sits on its stairs, his briefcase jammed behind him as he races through two newspapers.

In late 2002, Mr. Brorson and his team quit Northern Trust for money-management firm Neuberger Berman. The switch meant more pay and independence, but big-time pressure. The main goal in his old job had been to protect assets. But Neuberger Berman, now part of Lehman Brothers Holdings Inc., is determined to outdo the competition. It had fired his predecessor just before Christmas that year for being behind the curve. "The mindset is 180 degrees different," he says.

Mr. Brorson sets the direction for a variety of investment accounts including three mutual funds, letting portfolio managers pick most of the individual stocks. For three years, his team rode what proved to be a resurgent market, mostly staying ahead of the pack. But early this year, he got worried. A string of Fed interest-rate boosts was putting a drag on the economy, as were high oil prices. Yields of 10-year Treasury bonds had pushed above 5%, pulling mortgage rates up. Consumers showed signs of restraining their borrowing and spending.

Pulling out of a winning bet is one of the hardest things for investment pros to do. It means selling your strongest positions while others are buying and prices are high. Yet if you wait for stock prices to weaken, it may be too late. Mr. Brorson’s stomach churned as he cut back on stocks tied to economic strength, such as copper company Phelps Dodge and aircraft maker Boeing, and shifted into "defensive" ones such as Coca-Cola.

"It is hard to kick out the girl that brought you to the dance and go over to Bertha," Mr. Brorson says.

When the market cracked in mid-May, he was exultant, as his move to caution had put him ahead of the more-bullish competition.

By August, he was newly queasy. The Dow was up 4% since a mid-July low — and he was still with Bertha. Sitting in his office at 6:50 a.m. one day, he found himself nervously plowing through dozens of emailed analyst reports, scrolling through the headlines on his Bloomberg terminal, preparing to take calls from analysts and casting an eye toward the commentators on CNBC.

To do his job, he immerses himself in the market — the data, the commentary, the moves of various stocks and indexes. One computer screen is on his desk in front of him, and two others, for email and for charts, on a credenza behind him. Most days he skips breakfast and lunch, munching on nuts, raisins and bananas and drinking coffee and water.

That Monday in the middle of August, the market wasn’t going his way. The Dow had been down the Friday before, in line with his expectation, but now it was up 60 points, and his conservative stocks were trailing. With oil prices and mortgage rates by this time retreating, the market was betting on economic growth. More-speculative stocks linked to technology and consumer spending were leading. "We are giving back a lot of what we gained Friday," Mr. Brorson said, looking irritated.

CNBC reported that retailers, a group he had bet against, were rallying. "We knew that. Yup. Retailers are rallying," Mr. Brorson said. To process information, he regularly talks back to the TV screen, to his Bloomberg screen, or while listening to conference calls with his line muted.

Every morning, Mr. Brorson goes to the Web site of Morningstar, a mutual-fund research firm that compares funds to each other and to indexes. Thanks to his May move, in late August most of the funds still were ahead of the competition for the year, but slipping. He wanted to be able to report solid performance when the quarter ends today. "You don’t want to bleed to death at the side of the road from getting nicked, but I am not going to change anything," he said. "What I am worried about is a more sustained move that goes up 15%-20% into December. We would have to react to that."

He believed the upturn wouldn’t last. Meanwhile, he had bet that demand would keep energy stocks rising, and had hung onto them. Now, softer oil prices were pulling energy stocks down.

Other pros were selling energy stocks, "taking profits," and putting the money in beaten-down tech and retailing shares. "Very rarely does a sector lead for three consecutive years. I know that. And this would be year three for energy," he said. "But I am maintaining my position."

Although he bases decisions on fundamentals, Mr. Brorson occasionally peeks at another side of the investing world, called technical analysis, which tracks trends in historical and other charts. As he put it: "One of the oldest sayings on Wall Street is, ‘I am not a technician, but….’ " He pulled out a chart of oil prices, worrying that it seemed to have peaked and started down.

Ken Turek, who oversees the group’s biggest fund, and Spiro Voulgaris, who does its data analysis, had been pushing him with increasing urgency to cut back on energy. He was beginning to waver. But suddenly the tension eased. The day’s rally faded, and his more-conservative investments recovered. CNBC reported the news. "We knew it would do that. We knew it," he told the TV screen.

Mr. Brorson encourages those around him to think independently. In a staff meeting, Mr. Voulgaris said profit forecasts were rising, suggesting a stronger economy. But Mr. Brorson figured any gains in tech stocks would be a chance to cut holdings in them even more. "I hate these things. If they show any sign of life, shoot ’em between the eyes and throw ’em overboard," he said.

Over the next weeks, the market kept moving against Mr. Brorson. Economic reports reinforced hope the Fed was managing to cool the economy smoothly. The tech-heavy Nasdaq Composite Index was up 10% since mid-July. But rejecting colleagues’ entreaties, Mr. Brorson was unwilling to buy more tech or retail stocks.

By mid-September, the stress was intense. Exxon Mobil, a big holding, was off almost 9% from an August high. "We had a lousy August and we are coming up to the end of the quarter," Mr. Brorson said. "I want to see some butt-kicking. Where is the butt-kicking?"

One thing buoying the market, Mr. Voulgaris noted, was that investment pros who were still trailing the indexes they were measured against felt pressure to buy the currently hot stocks before the quarter’s end.

Mr. Turek walked in, and said some of his best stocks were the tech and retailing ones Mr. Brorson had asked him to sell, while some of his worst were the energy stocks Mr. Brorson liked. Displaying a downward-sloping chart, Mr. Turek asked, "If that were a stock, what would you do with it?" Then he showed a chart of consumer stocks such as retailers. Its angle was upward.

"Son of a buck," Mr. Brorson said, the closest he comes to swearing. "Dang it."

Mr. Brorson rechecked which sectors were leading — something he’d been doing almost every hour. Financials and health care, two of his favorites, were OK. Then he saw tech and retailing stocks pulling back a bit. He took a deep breath and relaxed. "You don’t have to swing at every pitch," he said. As the market sank to a close, he untied the shoelaces he has been tying and retying all day.

But the day ended with his energy stocks still suffering. "Crap and a half. It was a stinking, frustrating day," he said.

At 2:30 a.m. that night, unable to sleep, he says, he went to the living room and read some of "Uncle Tom’s Cabin."

The next day, the stress got worse.

"Today the Dow could be very close to making a new high that could break this wide open," he said. It was at 11580, less than 150 points from a record. He turned up CNBC. "There is a lot of optimism here on the floor," said a commentator.

"They are just a bunch of sheep," Mr. Brorson told the TV. He pulled out a stock chart and began drawing horizontal lines across its peaks and valleys. The work suggested the indexes were pushing back toward old highs. "Jeez," he said.

"We’re on a record-high watch for the Dow," said a cheery CNBC announcer.

"Time to sell. Time to sell," muttered Mr. Brorson.

Yet within days, he had shifted his bet. He told associates he had made a classic mistake of staying too long with a winner: energy stocks. "I should have sold out when Ken wanted me to and Spiro wanted me to. So let’s close the barn door when there is still a part of the horse left," he said.

They debated where to put the cash. Still expecting a weaker economy, Mr. Brorson wanted defensive stocks such as makers of food and household products. Mr. Voulgaris disagreed. "History suggests that headwinds haven’t slowed the consumer in the past," he said, adding that auto-industry cutbacks, paradoxically, would put more money in people’s pockets as they took buyouts. The staff compromised and spread the cash around, to stocks they already owned.

Mr. Brorson knows that if the market keeps defying his expectations, he will at some point be forced to start buying the winners, or risk falling behind. "I do believe we are at the midpoint in a much more elongated cycle, where China will be spending money to support the 2008 Olympics," he said. But he didn’t want to position himself for that yet.

In a belief that quarterly profits, due out in October, could disappoint, he and his colleagues agreed late this month they won’t chase the tech and consumer stocks. But they reminded themselves that, in the fourth quarter, technology often is a leading group. Their expectation: Techs will pull back after earnings reports; then they’ll be prepared to buy.

The goal, Mr. Brorson repeatedly reminds himself, isn’t to be right, it’s to own winning stocks. "It is not a moral thing, about who is right and who is wrong," he said. "It is just money and we are paid to make it grow."

The contrast between Brorson and Buffett couldn’t be greater. The following are excerpts from an article profiling Warren Buffett at work in the Wall Street Journal in November, 2006:

Mr. Buffett has relied on gut instinct for decades to run Berkshire Hathaway Inc. Watch him at work inside his $136 billion investment behemoth, and what you see resembles no other modern financial titan. He spends most of his day alone in an office with no computer. He makes swift investment decisions, steers clear of meetings and advisers, eschews set procedures and doesn’t require frequent reports from managers. Occasionally he picks up the phone, calls his broker and trades $100 million or more of stock.

Mr. Buffett calculates that since 1951, he has generated an average annual return of about 31%. The average return for the Standard & Poor’s 500 over that period is 11% a year. A $1,000 investment in Berkshire in 1965 would be worth about $5.5 million today. Over the past decade, Berkshire shares have tripled in price, returning twice as much, in percentage terms, as the S&P 500. Berkshire’s Class A shares closed yesterday at $90,500. In recent years, the company’s growth has slowed, as Mr. Buffett has become wary of deploying cash reserves due to market conditions.

Even the job of investing Berkshire’s $45 billion stock-investment portfolio — bigger than all but eight of the 7,063 U.S. stock mutual funds tracked by Lipper Inc. — is far less systematic than it is at most investment firms. Berkshire has no investment committee or asset-allocation guidelines, and Mr. Buffett does not meet with analysts or advisers.

He chatted briefly with his assistant, then hurried into his modest-size office and shut the door. There is no computer in there, nor is there a stock-quote machine or stock-data terminal. He keeps a muted television set tuned to CNBC, the financial-news network. Although he occasionally carries a cellphone on the road, he does not use one in Omaha. He keeps no calculator on his desk, preferring to do most calculations in his head. "I deplore false precision in math," he says, explaining that he does not need exact numbers for most investment decisions. On the cabinet behind his desk are two black phones with direct lines to his brokers on Wall Street.

He had barely settled into his seat when one of them rang. It was John Freund, his longtime broker from Citigroup Inc.’s investment-banking unit. Mr. Freund briefed Mr. Buffett on a stock position he had been building for Berkshire. "If we bought a couple million, that would be fine," Mr. Buffett said, giving Mr. Freund a parameter for how many shares he wanted to buy that day. (Mr. Buffett declines to identify the stock.)

By the end of the day, Mr. Buffett had bought $140 million of the stock for Berkshire’s investment portfolio — equal to the entire asset value of many mutual funds.

Even with such heavy trading, Mr. Buffett’s desk isn’t littered with stock research. "I don’t use analysts or fortune tellers," he says. "If I had to pick one, I don’t know which it would be."

Mr. Freund says that when Mr. Buffett is buying stock, he pays little attention to some factors that shape other investors’ decisions, such as the economic climate. "He doesn’t wait to see what the Fed is doing" to make a trade, Mr. Freund says. Mr. Buffett also can move more quickly than his other clients, he says. "There is no investment committee," the broker explains. "That allows him to make immediate decisions."

Mr. Buffett has allowed about $40 billion of cash to accumulate at Berkshire because he hasn’t found many attractive investments over the last couple of years. Some investors doubt that shareholders would stay patient if anyone other than Mr. Buffett had such a large cash horde, "especially when it is competing with so much hedge-fund money and mergers-and-acquisition activity these days," says Thomas Vandeventer, a portfolio manager at Citigroup Asset Management, which holds some Berkshire shares. Cash doesn’t generate income, and some investors want their money fully invested.

It’s unlikely that any successor would choose investments or acquisitions quite like Mr. Buffett does. He says he knows an attractive acquisition candidate when he sees it. "If I don’t know it in five to 10 minutes," Mr. Buffett says, "then I’m not going to know it in 10 weeks."

Brorson’s and Buffett’s styles couldn’t be more different. 

Buffett couldn’t care less what the market does day to day because he buys stocks of good businesses that are trading at a discount to their intrinsic value.  Brorson frets hourly about the machinations of the market and can’t stand being in the "wrong" sectors. 

Buffett’s time horizon is close to forever.  Brorson’s is to the end of the quarter.   

Buffett believes the market is there to serve you and provide liquidity, not to instruct you.  Brorson believes that there’s information to be gleaned from looking at leading sectors, daily price movements and the occasional stock chart. 

Buffett believes the market is usually wrong in the short term and can’t be trusted to tell you if your stock picks are right or wrong.  The true test of being right or wrong comes with long-term performance.  Brorson believes the market will tell you whether you are right or wrong by your short term performance – if you’re making money at the end of the quarter, you’re right.  If you’re losing money at the end of the quarter, you’re wrong. 

I would argue that Brorson’s approach is more appropriate for traders who are trying to benefit from short term movements in stock prices.  If you are trading, then you have to cut your losses short, stay in strong sectors and make sure you are positioned correctly in the short term.  Like Brorson, most fund managers who claim to be investors are actually traders.  The typical turnover at a mutual fund is over 100% during a year. That’s not investing – that’s swing trading.  But this is exactly how most professional money managers approach the market because it’s their own time horizon.  When they outperform over a couple of quarters they get a bonus.  When they underperform for a couple of quarters, they get fired.

This approach is completely inappropriate for long-term investors.  Worrying about one quarter’s performance vs. the index is silly if you are an investor and your time horizon is 20 years.  Long term investors should be looking for 1) good businesses that are temporarily out of favor and trading at a discount to intrinsic value or 2) growth companies with a "moat" around the business that are trading at reasonable valuations.  Worrying about which sector or stock is outperforming today versus yesterday is a classic way to ensure you will buy at the top and sell at the bottom.