Frank Thoughts: The Last 62 Years
Frank Boland
July 12, 2023

The enclosed chart of Fed funds is illustrative of what enabled the outperformance of active managers at the start of the modern investment era and what subsequently penalized their performance for the last 30 years.  The cause: it was the dramatic rise and fall in interest rates. The chart shows, the secular direction of interest rates moving up from less than 1% for 27 years to 20%, and then back down for 27 years to 0%. A perfect parabolic move. When I first saw the chart, my mind went back in time. After all, I had been in the business for 59 of those years. Something struck me as odd. But I couldn’t quite understand it.

Rising interest rates should make investing more difficult as the economy fades into a recession, how then could active portfolio managers do so well? My mind went back decades ago to meeting Joe McNay outside the Fidelity Investment building. At the time, he was working for the Massachusetts Company and was responsible for the Benjamin Franklin family trust. He had always worked as a manager of separate accounts. His first account was his Yale classmate’s 25th class anniversary gift to Yale. They gave him $370,000 in 1954; in 1979 it was worth $90,000,000! That’s 24.6% per year!

Then I thought of Jerry Tsai, the first mutual fund manager to become famous. Starting in 1958 he managed Fidelity Capital (three years after Joe McNay had started). As we previously wrote about, in 1965 Tsai left Fidelity hoping to raise $25 million for his new Manhattan Fund. Instead, he raised close to ten times that amount. It was the start of a wave of portfolio gurus. Peter Lynch in 1977 became the manager of the then small Magellan Fund. All three “rode” a secular wave. A wave that had started in 1955 when Fed funds were under 1% and lasted until 1982 when Fed funds crested at just over 20%.

From there began a 40-year decline in interest rates which culminated with rates at 0% by the end of 2008. This past l4-year experience of 0% was the coup de gras for the reputation of active managers. On a whim, I googled “Famous Stock Managers Since 1980.” It produced more than a dozen names. All of which I was familiar with, but not one was a mutual fund or separate account manager; all were hedge fund managers of fixed income. John Paulson – a representative example - made a fortune in the debt crisis of 2008-2009 but gave much of it back after his entry into active stock management.    

Of course, the larger question is, why should the price, direction and most importantly the time duration of higher interest rates, have such an impact on individual stock valuations and portfolio performance? Forgotten during declining interest rates is that the purpose of a business is to make money. Anyone can sell a product or service for less than it costs. Profitability is the only realistic determinant of a business’ value. With Fed funds currently at 5% and inflation also at 5%, you still have 0% real interest rates ... which is where we currently are. If it stays there, we need at least 8%.

When Fed funds move higher – and stay higher – they become the driving force that creates dispersion in the stock market. But these higher rates must stay higher.  When Peter Lynch became manager of the Magellan in 1977 Fed funds were 4.5-5% (as now) on the way to 20%+. Lynch beat the S&P 500 11 out of 13 years averaging 29% a year. Higher rates force profitability in a business, and that creates differentiation in the stock market. As we postulated in the beginning, the opposite is also true. As Peter Lynch said in 2020 about the prior year, “… the worst relative year I’ve ever had in 50 years. I’m up, but I’m not going to give you the number. The market is up 29%. I’m nowhere near that.”

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