First Quarter 2014 Letter to Clients

There is an underground data storage facility in southeast Texas known, curiously, as the Montgomery Westland Bunker. For all intents and purposes, it seems like any of the other such facilities that have popped up all over the country in the age of cloud computing, designed to give large corporations a safe place to run redundant computer operations in the event of a natural or manmade disaster.

But the story behind the Montgomery Westland Bunker is decidedly unique; in fact, as the facility’s own website puts it:

“The origins are complicated.”

As conceived by its builder, Louis C. Kung, the bunker wasn’t so much a bunker at all but rather an underground city of sorts. It was constructed during the height of the Cold War in the late 1970s, when tensions with the Soviet Union were at their peak. Mr. Kung had made his fortune in the Texas oil boom of that same era, and he was obsessively worried about what he perceived to be the “inevitable” nuclear exchange the two Superpowers were, in his opinion, destined to have.

Not one to sit idly by, Mr. Kung set about doing something to protect his interests. As the new corporate headquarters for his Montgomery Westland oil company were being constructed on the outskirts of Montgomery, Texas, he directed the construction of a secret city some 70 feet underground. The 40,000 square foot bunker town was a top secret project, protected by armed guards patrolling the perimeter. It was designed to house 350 people for up to three months in the event of a nuclear attack. The facility included mini-compounds for the residents, a dining facility, hospital, decontamination sites – even a jail.

Doing his best impression of a James Bond movie villain, Mr. Kung even had his own mini-army to defend against the panicked masses whom he was sure would storm the compound in the coming nuclear disaster. Gun turrets disguised as decorative pagodas guarded the bunker entrances (see inset below).

Clearly, Louis C. Kung was a man who planned for every aspect of what he was certain the future had in store. And then something happened he never planned for. The Texas oil industry collapsed in the early 1980s, and Mr. Kung’s fortune collapsed along with it. He lost title – and with it, access – to the headquarters and the hidden city he had constructed underneath it. Not that it mattered anyway, of course, for the nuclear war he was certain was coming never came. The bunker sat like a Cold War time capsule, untouched, for decades, a monument to the futility of one man trying to anticipate and plan for forces that were well beyond his control. The bunker was ultimately purchased and converted to its present, more practical, use as a data storage center. As Mr. Kung lay on his death bed in 1996 contemplating all the money, time and resources he had devoted to preparing for something he was certain was inevitable and yet never came to pass, one wonders what his emotions were. Chagrin, we suspect.

In a macro sense, Mr. Kung was an investor who made a bet with his capital. And though it was a bet on a scale most of us can’t conceive of, there is a cautionary tale here for all investors. Fear is the most powerful human emotion, and anxiety about the future is something we all must grapple with. This anxiety is also the most destructive force known to investors, because it causes otherwise rationale individuals to make extreme, emotional decisions with their money. Those emotion-based decisions usually involve making bets and suppositions about where to invest one’s money to protect it from an anticipated threat. We saw this vividly in 2008 and 2009, when investors fled to the perceived safety of cash to “protect” their capital, sure in the knowledge that things were only going to get worse.

And yet the future never turns out quite like we envision it. Unanticipated events shape the world in ways we could have never imagined. Strategies that bet on one scenario usually end disastrously when events don’t unfold the way they were expected to. Just ask all those investors who were betting on Dow 5,000 and instead are staring at Dow 16,000 today.

That’s why diversification is the only logical way to approach a rapidly changing world. Diversification is the only investment strategy that relies, not on bets and assumptions, but on spreading risk as much as possible so that bad bets and incorrect assumptions don’t destroy our wealth.

That was a lesson that Louis C. Kung, alas, learned the hard way.

* * * * *

Along those lines, perhaps the most common anxiety we are hearing these days is from individuals who are worried about putting money to work in their long-term investment portfolios with the market “due for a downturn.”

Statistically there is some truth to this; bear markets, defined as a decline in the stock market of 20% or more, have historically occurred about every three years. With the last such downturn being in 2011 on the heels of the U.S. debt crisis and subsequent credit downgrade, it isn’t a stretch to think that a bear market in the short term isn’t just possible but even likely.

We need, however, to do a deeper dive on this premise, because it leads to false assumptions about the predictably of downturns. Remember that the stock market moves in extremes, and averages only present themselves in retrospect, over many years. For example, if we look at the history of bull markets, we see that the average such market has run about five years in duration, with an average gain of 185%. But these are only averages; many bull markets lasted far longer and saw much higher gains. In fact, the 13-year bull market from 1987 to 2000 saw the market gain 582%!

Clearly, investors who sit on the sidelines in a bull market waiting for a market downturn run a real risk of missing out on huge gains the market may yet be poised to deliver.

For the sake of discussion, however, let’s examine the fate of two investors who invested around the time of what many would consider a worst-case event – “Black Monday” 1987, when the market dropped 22% in a single trading session. From a short-term investment perspective, it doesn’t get much more extreme than that.

As we can see in the following chart, an investor who put money in the market just before the event, in September 1987 did, indeed, fare worse than one who got in just after the event, in January 1988 – at least for the next five years. What’s interesting, though, is how, over the course of time, the gap narrows between these two hypothetical investors; today the difference in their long-term performance would be about 1.28% annually.

Yet while that differential isn’t insignificant when compounded over time, even the unlucky investor who entered the market in September 1987 fared much better than one who stayed in cash (green bar) even after only 10 years. The lesson here is that, although we’d all like to be the lucky investor who puts money to work in the stock market after a big downturn as opposed to before, the most important thing is to put the money to work. History shows that long-term investors will always end up worse off sitting around in cash than they would investing their money in the stock market – regardless of whether they invest at a historically high or low point.