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The Science of Hitting
The Science of Hitting
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'If I Take Netflix Out of My Portfolio I Lose One of My Biggest Winners'

Some thoughts on the conflicts of interest for an investment adviser between running their business and making intelligent long-term decisions for their clients

July 05, 2018 | About:

I recently listened to an episode of the QTR podcast that featured Ross Gerber, an investment adviser with the firm Gerber Kawasaki. During the podcast, Gerber discussed his investment in Netflix (NFLX). As you might suspect, he has made a killing for his clients since he bought the stock (it’s up more than 100% since the start of 2018). After some prodding by the host about the stock's current valuation, Gerber bluntly stated that Netflix shares are “ridiculously expensive.”

He put some numbers on that, saying that he believes the business deserves to trade at 6x to 7x sales. For context, Netflix should generate somewhere around $16 billion in revenues in the current fiscal year (using Goldman’s estimates). Against a current market cap of roughly $175 billion, that’s a forward price-sales ratio of roughly 11x. Relative to 6x to 7x sales, the stock is roughly 60% above his estimate of fair value. That’s a pretty big gap.

When asked about why he continues to own the stock if it’s clearly overvalued by a wide margin, here’s what Gerber said:

"If I take Netflix out of my portfolio, I lose one of my biggest winners."

I give Gerber a lot of credit for his sincerity. I think most investment advisers, whether they would admit it or not, think similarly when they buy or sell individual stocks for their clients. There’s an unwillingness to sell stocks that have done well, particularly if they’re widely perceived as being a company that will be dominant in the future (the FANG stocks come to mind).

On the other end of the spectrum are the companies that have fallen from grace and that have seen their stock prices lag the S&P 500. It’s ten times worse if the stock has lost money. When you sit in a client meeting, it often feels like these are the only stocks that clients want to talk about. As a result, advisers hate these stocks, particularly if the name has been a loser for a long time and if the situation is complex (which makes those conversations uncomfortable). I think the current posterchild for this group is General Electric (GE). Most advisers avoid that kind of stock like the plague.

The reality is that many people in the investment advisory business make decisions for their clients based on considerations that have nothing to do with the attractiveness of the security in question. Their primary concern is career risk. And that risk for one adviser is an opportunity for others to win new business. As Gerber explained during the podcast, continuing to own a "ridiculously expensive" but widely loved stock like Netflix also presents a substantial opprtunity for advisers:

“We see accounts and we go ‘Oh, your adviser didn’t buy you Netflix? Your adviser didn’t buy you Google? What are they doing?’ And everybody’s like ‘I don’t know.’”

When the host retorted, “Maybe they’re looking at the valuation.” here was Gerber's reply:

“Right, but the problem is that the clients are seeing the gains [on TV or in the financial press] and they’re not getting it. And we’re taking those clients from those advisers.”

Again, I applaud Gerber for his sincerity. I think the sentiment he has shared is quite common in the investment advisory business. If this is a path to assets under management, there's no question (some) advisers will do it. Again, the primary objective isn’t to generate the highest risk-adjusted rates of return for your clients. It’s to keep clients happy and reduce career risk -- even if that means doing things that are not in their financial interest over the long run.

In Joel Tillinghast’s “Big Money Thinks Small,” he shares a vivid example of what an investment manager can face when they take a contrarian stance and refuse to engage in activities that they view as harmful to the long-term financial health of the end client.

In the book, Tillinghast discusses the tech bubble of the late 1990s and some of the insane price action he witnessed. One example is Sycamore Networks, which went public at $38 per share. By the end of the first day of trading, the stock had climbed an astounding 384% to $184 per share. Crazy, right? Well, over the next four months, the stock tripled again. At its peak, Sycamore had a market cap of $44 billion – compared to peak sales of less than $400 million. Tillinghast did not find value in these kind of situations and largely avoided tech stocks during the late 1990s. The result?

Roughly half of my funds went out the door during the internet bubble.”

A decision we all view as rational and good for investors in the fund (at least in hindsight) cost Tillinghast half of his assets under management. I don’t know how his compensation worked at Fidelity, but if you own an independent investment adviser business the entirety of those lost fees come directly out of your pocket. The reality is that an adviseer has a real incentive to stick close to the herd, even when he or she has reason to believe it’s not in the best interest of their clients.

This is a really difficult problem to address, for a reason that Gerber captured succinctly during the podcast appearance: “We’re dealing with humans.”

In a perfect world, advisers would spend more time on upfront education to ensure clients at least understand the basics of their investment philosophy. From there, the client would keep a watchful eye, but would leave the decision-making up to the adviser. They wouldn’t nitpick individual decisions or judge them against the noise of short-term market fluctuations. Sadly, in my experience, this is a mile away from how this actually works. I think there’s blame to be shared by both parties.

I don’t have an upbeat conclusion: Whatever side of the table you’re on, you should do what you can to encourage long-term thinking and rational decision making. If your adviser isn’t willing to openly discuss their process, find somebody else to work with. I would do the same if they rarely say “I don’t know” or if they are not open about the challenges of navigating the current investment environment.

At the same time, you should come to the table with realistic expectations about what your investment adviser has to offer. At least understand the basics. Considering that you’re talking about some of the most important financial decisions you’ll ever make in your life, it’s worth your time.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 5.0/5 (12 votes)

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Comments

Dr. Paul Price
Dr. Paul Price - 5 months ago    Report SPAM

That's just another reason why smart investors need to learn to evaluate stocks on their own, sans advisors.

The Science of Hitting
The Science of Hitting - 5 months ago    Report SPAM

Dr. Paul - That's a potential solution as well. Thanks for the comment.

batbeer2
Batbeer2 premium member - 5 months ago

Thanks for sharing your thoughts.

In this business I guess you can only be as smart as your dumbest client. So yes, educating your clients helps.

The Science of Hitting
The Science of Hitting - 5 months ago    Report SPAM

Batbeer - That gets to another part of the problem. There are clients who show up at the RIA's door that do not have the ability or willingness to appreciate the investment philosophy (and the trade-offs that come with that approach). Said differently, some clients are just a bad fit. But this is in direct conflict with the financial interests of the advisor. For each incremental dollar of AUM, a large percentage of those fees flow directly to the bottom line. So what do most advisors do? They take on the client even though they know it's not a great fit and will probably end badly. This is another example where I don't have a great answer to the problem. Thanks for the comment!

batbeer2
Batbeer2 premium member - 5 months ago

>> They take on the client even though they know it's not a great fit and will probably end badly. This is another example where I don't have a great answer to the problem.

In my view it is immoral to take money from someone you say will benefit from your services but know probably won't. What's more, it is bad for your other clients. If you do exactly what you say (stick to your philisophy), then you close your fund when fools come flooding in. Some funds do exacty that. The largest funds by definition don't.

This is not going to change any time soon but IMHO the solution is simple. Hard to do but simple.

snowballbuilder
Snowballbuilder - 5 months ago    Report SPAM

@science and batbeer interesting discussion if I could add a related thoughts

if you are a good investor with some money you don't even need any client (out of you and your family) To become wealthy and have freedom

best snow

The Science of Hitting
The Science of Hitting - 5 months ago    Report SPAM

Batbeer - I think the reality (IMO) is that these advisors do what most people would do in their situation: they convince themselves that they can make it work, even if an objective outsider would say that's silly. That conclusion is heavily influenced by incentives (fees). The larger the potential account, the more likely it is that the advisor will find a mental work around for a "bad" client.

I also think many advisors believe that the "cost" (in terms of time and energy) will not be too bad if they're wrong. They'll spend a few quarters or a few years trying, and if it doesn't work, so be it. Like you, I'm not convinced by that argument. I think it is a disservice to your "core" client.

Finally, I couldn't agree more with your last two sentences. Thanks for the comments!

The Science of Hitting
The Science of Hitting - 5 months ago    Report SPAM

Snow - Agreed. But even then, the reality is that the investment advisory business is not going anywhere. And to be clear, in case I haven't been so far, I think advisors can actually add value for their clients. What's important (IMO) is ensuring a good fit and establishing a proper relationship - setting realistic objectives, addressing the behavioral components of investing, etc. Doing that stuff requires work on both sides, and it may require difficult decisions like passing on AUM when the client isn't a good fit.

Finding that type of advisor isn't easy. But for the average person who doesn't work in the industry or spend their free time thinking about investing, this type of help could be quite valuable.

Ryan Harding
Ryan Harding - 5 months ago    Report SPAM

Very interesting insight into money manager's thinking.

I wonder if they could partly resolve the conflict by keeping Netflix in the portfolio for the marketing angle - to be able to show off the performance of their big winner from the time they purchased to the present day - but at the same time they could severely trim the position size when it gets overvalued to enhance the portfolio performance going forward so that if it declines, it will have a negligible negative impact on the performance (though it may trigger some taxes on the realized gains, presumably they'd be worth it).

It seems like that's a way both to have your cake and eat it too, even if it's a little disingenuous to hollow out the cake like that!

If you're simply marketing for AUM you can then spin it as 'participating in the performance of Netflix' if it rises or as 'wisely trimming the exposure in light of overvaluation' if it falls to keep the investors happy ni the short term, while hopefully setting them up for good long-term value creation. If you're looking to select partners with the right attitude rather than accumulate AUM and 'manage' your message, you might be able to be more forthright and direct!

batbeer2
Batbeer2 premium member - 5 months ago
If you read a couple of letters by Francis Chou (Trades, Portfolio) you get some idea of the alternative.

One policy Chou has for his funds is that clients who leave early pay a "fine" that is then distributed among the remaining clients. It's not a big deal (matter of months) but it makes clients think twice before investing with him which is probably exactly Chou wants to achieve. Also it probably scares off almost all fund-of-funds type funds as well as some of the know-nothing pension fund managers. Exactly the types who would redeem at the worst possible moment.

So Chou gets fewer clients but the ones he has understand that you can invest with a long-term horizon or sit on liquid assets but you can't claim to do both.

Perhaps it's coincidental but Chou does best in down markets.

Just some thoughts.

vgm
Vgm - 5 months ago    Report SPAM

Seems Gerber is ignoring what Buffett calls the three most important words in investing: margin of safety. It cannot end well in the long(er) run.

Reading Tillinghast's comments, I'm reminded of J-M Eveillard's quip during the dotcom bubble when asked why he was not buying tech: I'd rather lose half my clients than half my clients' money.

Seth Klarman (Trades, Portfolio) talks a lot about the quality of his clients, savvy families and business people, and how their expectations are well aligned with Baupost. In the midst of the 2008-9 financial crisis, he was able to go to them with what he had ascertained were exceptional bargains and his clients responded.

Howard Marks also stresses the critical importance of aligning client expectations with deliverables.

Thanks for the stimulation, Science.

The Science of Hitting
The Science of Hitting - 5 months ago    Report SPAM

Ryan, Batbeer and Vgm - Thanks for the comments! A lot to think about there.

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