Morningstar Magazine - August/September 2017 - 15

Advice to the Graduate
The future belongs
to algorithms.

THE OLD SQUIRREL

Ralph Wanger

The views expressed here are those of the
author and do not necessarily reflect the views
of Morningstar.
This past spring marked the 50th anniversary of The
Graduate, which should be of interest to
financial analysts. The 1967 movie had an annoying
subplot about the seduction of a young college
graduate by a glamorous older woman, but for our
purposes, the key event was an economic
forecast. Mr. McGuire, a boring middle-aged man,
advises 21-year-old Benjamin Braddock (Dustin
Hoffman): "I just want to say one word to you. Just
one word ... Plastics."
The line became a cliché laugh line as an example
of misplaced enthusiasm for an industry marked
by conformity, superficiality, and pollution.
However, the plastics industry would have been
a great place to work. Over the next 20 years,
the annual production of plastics in the world
increased at a compound growth of 11% per year.
There was also enormous innovation in the
plastics industry. Your cellphone, eyeglasses, and
private jet are lightweight, durable products
because of the advanced plastic in their frames.
Being a Williams graduate, Benjamin could
have joined the Pittsfield, Mass.-based company
GE Plastics. GE Plastics would grow to 11,000
employees, $6.6 billion in sales, and $675 million
profits. Benjamin would be 71 years old now,
a wealthy retired vice president of marketing, and
sad that GE sold his division to the Saudi firm
Sabic for $11.6 billion.
From an investor's perspective, however, plastics
was a hard industry to make money in, because

most plastics manufacturers were divisions of Dow
DOW or Union Carbide. The major chemical
compa-nies were good stocks in the 1950s and
1960s, but it was a maturing industry. Great stock
stories were infrequent. In my mutual fund
company, we did not even bother to hire an analyst
to follow the chemicals. Even if you expanded
the definition of chemical companies to include
rubber, glass, steel, aluminum, paper, and
fertilizer, the story wasn't very different. Most U.S.
manufacturing companies have stagnated
or disappeared.

to build an electronic slot machine. A $20 chip
created an $8,000 slot machine that drove $50
million casinos that helped Las Vegas boom.
Acorn Fund made big money owning both
International Game Technology IGT and several
casino companies.

Benjamin is an illustrious member of a class of
young men who become involved with older
women. Another such man is Emmanuel Macron.
He was elected president of France in May,
but one could pretend that he had lost the election
and called me up for advice on what career a
young man ought to pursue. Could I come
up with something as wise as what Mr. McGuire
told Benjamin?

Who has gleaned the most success from hightech? Mark Zuckerberg figured out how to use the
Internet to link everybody's phones and assemble
a 200-petabyte file of cat videos. Amazon.com
AMZN took over the bookstore business and is now
on track to acquire the rest of the universe.

"Just one word ... Quant!"
Portfolio managers in my era were storytellers who
swapped tales of exciting stocks. People like Peter
Lynch and Mario Gabelli became rich and famous.
But we are being replaced by computer programmers who have Ph.D.s in physics, not MBAs.
Computers use algorithms to solve problems. I think
most portfolio managers who succeeded did
so based on a couple of simple mental algorithms,
sometimes called "heuristics," or "theme investing."
In my case, I chose smaller companies
because they were cheaper than the successful
blue chips. I had one very profitable theme, which
I called "downstream from technology."
What did that mean? Well, in 1955 the big technology idea was the automobile and the
freeway. Buying General Motors GM would have
been a bad long-term idea. But autos and
highways created the suburbs, and companies
that bought land near a highway interchange and
built a shopping mall were wildly successful.
In 1975, geniuses made electronic stand-alone
computers practical. Downstream, a few
shrewd nongeniuses used cheap microchips

Cellphones and the Internet are amazing examples
of high technology. That does not make them
certain sources of long-term wealth. Companies
such as Nokia NOK and BlackBerry BBRY, leaders
a few years ago, are now struggling.

In investing, we have now established that an
algorithm (indexing) can produce good
returns with no tracking error. I think that there
will be rapid evolution in the next few years.
The index algorithm "buy a little bit of everything"
is a boring rule. Humans, because they are
storytelling animals, will try to come up with better
rules. We are learning how to analyze Big Data
and use artificial intelligence to do it.
Most of us think that there are some anomalies
in stock pricing that can produce big profits.
My belief in small companies exploited a specific
risk premium that allowed Acorn Fund to
beat the large-cap S&P 500 by an annualized 3%
over a 40-year period.
In the next few years, we will see hundreds of new
quant funds set up to exploit perceived anomalies. The public will be attracted to them: Anomaly
hunting is a better story than index-hugging.
A lot of these algos will just be "data mining." That
means that the rule they are using will only work
for a short time. Well, if you are running a gold mine,
it won't last forever either. Grab what you can
while the gold ore is plentiful and sell out a year
too early. You only have to get rich once. K
Ralph Wanger, CFA, ran Columbia Acorn Funds from 1970
to 2003.

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Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2017