Resisting The Madness Of Crowds

Resisting The Madness Of Crowds
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Portfolio Manager Buzz Zaino discusses the importance of maintaining investment discipline in the face of investment manias and trends.

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Steve Lipper: You've seen a number of manias through history, most of which haven't worked out well for investors. What's your perspective on ETFs and how they're similar?

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Buzz Zaino: There are the manics and depressives of every cycle. And in the manic period, you can put enough money into the favored things and the ETF makes sense.

It's an easy way to invest your money without you really worrying because it's what everyone else is doing and it feeds on itself. It's been successful in the short term. So, you can be quite complacent, and that has happened in every cycle. There is the complacency, you know, evaporates one day, and then you've got a problem.

And then there will come a point in time when some perturbation happens, as always happens, on Wall Street, and there is a selloff in the stock market and the 30 multiples that might exist then in the ETF will contract to a 15 multiple.

I know we were talking about history, but if you go back to that period of time when the mutual funds lost a lot of money, people didn't want to get involved in speculative stocks, and they just kept putting money into the biggest and best companies. But the valuations have become excessive. They were 40 and 50 times earnings in the early 1970s. And when the market got very weak, they contracted back to 15 and 20 times earnings.

And if you look at the history of the Dow Jones average, it hit a peak of 1,000 in 1965. It did not exceed 1,000 until 1982. That was 17 years of no appreciation. So, if you bought a Dow Jones ETF in 1965, you would have had no appreciation. And that was a period of time when prices of things at least tripled.

You're creating something where there are no restraints on valuations and there are no restraints on liquidity, which will have an unhappy ending. We hopefully are the responsible managers, and even if we underperform for little periods. The stock market, of course, always has cycles and goes down.

Tuning Out the Noise

SL: So, now let's talk about the challenge of when everybody around you, whether it's the '90s or now with the ETF is buying the things that you're not buying. How do you maintain your discipline in a time when the most popular thing is the thing you're not doing?

BZ: Well, we actually can take advantage of it. Because, as you know, we're the small-cap investor and this provides a certain amount of liquidity. There is somebody to pay a silly price for the thing; you can sell it to somebody. With small stocks, it's very important to have a buyer when you're choosing to sell.

In the small stock sector, it is always a stock selection process that's very important, and you can make the rational decisions. And I tell the folks that I work with "Don't tell me about daily performance because that gives you a very bad bias." But let's concentrate on valuation criteria.

In our particular fund we have strict criteria. It has to be statistically valid for a value fund. And if it's not we just don't participate. And that's why we do so very little in the IPO market. And we successfully have avoided major traps. And we also use the factor of lack of concentration.

I like diversity because small stocks, there are always black swan events that happen on a regular basis with these smaller companies. And, you know, any one stock can turn sour on you and that makes you feel bad but it doesn't destroy the portfolio it tends to be an annoyance and you deal with it. There are also, you know, some of these stocks that do extraordinarily well, and the ETF makes them even more extraordinarily well, and you can just, you know, sell into increasingly rising markets in that particular case.

Article by Buzz Zaino, The Royce Funds

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