MANAGING YOUR MONEY : THE RIGHT PATH : Adapting to Wall Street’s New Terrain : A money manager says investors in the ‘90s will have to be more disciplined in the prices they’re willing to pay.

Times Staff Writer

George H. Michaelis, one of Southern California’s veteran money managers, has run the Source Capital investment fund and the First Pacific Advisors mutual funds since 1978. Michaelis’ style--patient, conservative and value-oriented--has paid off well over the long term. Even so, along with many individual investors, Michaelis has watched with concern as stocks, bonds and other investments have performed almost uniformly poorly this year.

Here, the 53-year-old Michaelis talks about his investment approach and how he’s preparing for what he sees as a vastly changed investment terrain in this decade, especially regarding stocks. Staff writer Tom Petruno interviewed Michaelis in his West Pico Boulevard office in Los Angeles.

The lesson of this year seems to be that the rules of investing are being rewritten for the ‘90s, versus what we knew in the ‘80s. What are the big differences you see?


Michaelis: The ‘80s were a period in which returns on stocks were above average, primarily because valuations expanded. Yes, there was economic growth in the ‘80s, but a major contribution to above-average stock returns came from valuation expansion.

Meaning that investors were willing to pay, say, 20 times earnings for a stock where they earlier would pay only 10 times earnings?

Michaelis: Yes. And somewhere in the middle of the decade, the process got out of control. Takeovers began to distort the capital markets and values. Nobody ever considered what the downside might be. That revaluation process was an extremely powerful one. But it doesn’t go on forever.

So the process is reversing now?

Michaelis: What happened this summer was very reminiscent of what happened during the summer of 1973. In that summer, the valuation of the small stocks just collapsed. But you didn’t see it right away in the Standard & Poor’s 500 or the Dow industrials (the big stocks).

Now, it’s not yet as extreme as it was in 1973. But I think valuations probably are in the process of coming down in the aggregate. I think it’s still early in the process.

It sounds, then, like you’re not interested in stocks now.

Michaelis: Actually, we’ve been a net buyer of stocks since August. But we’ve been very defensive. We’re an equity investor, yet we’re only in the low-60s (stocks as a percentage of a total portfolio). We have not gone and piled in.

I don’t think anyone can time the market. What the current situation requires is that you lengthen your time horizon. If I’m right about a company, three years from now we’ll be in good shape. But it might be that long. This is a period where chances are you’re going to look stupid in the short run.

If valuations overall are coming down, how do you pick stocks that will reward you, even in the long run?

Michaelis: It’s back to fundamentals. It sounds old-fogey, but old-fogeyism is in again. The successful investor in the ‘90s is going to have to be more disciplined in the prices he’s willing to pay for stocks. And there will be much more of a premium placed on being right over the long term.

If you were sitting on a lousy stock in the ‘80s, it may have been taken over, and you’d have said, “Boy am I lucky!” That happened a lot.

Now, companies are going to have to live with their operations (as the determinant of their stock price). The economics of stocks are going to be related to real profit returns again.

OK, so you’re looking for stocks that are bargains relative to the companies’ true potential. How do you judge them?

Michaelis: I’m driven primarily by the quality of the business I invest in. Value investing has two dimensions. Either you’re interested in buying assets, or in buying earnings power. I’m not interested in buying assets. I buy earnings power; that’s what works for me. I’m really only interested in buying a business where there’s a proven record of high rates of return on equity. I don’t look for rapid growth areas. I look for good businesses.

Circuit City is an example. It has a proven record of large-scale retailing of electronics and appliances. They’re probably now in only half the markets that could support them nationwide.

The stock is down from $29 to $11 this year (traded on the NYSE). It now trades at about six times earnings. The stock has been killed for a variety of reasons, including the potential impact of a recession on consumer spending and concern about the Southern California market, where two competitors are coming in to fight them.

I don’t know what’s going to happen to earnings in the short run. On the downside, the company might earn as little as 70 cents a share in a year. But if I’m right, the payoff on the other side of the recession two or three years out should be very good. I think by then Circuit City will have a lot more troops selling at a lot more locations, and the company’s earnings power will have expanded commensurately.

What else looks good now?

Michaelis: The electrical connectors business. It’s a great way to play technology. It’s a much more stable business. All the companies do reasonably well, but AMP (recently at $41, NYSE) and Molex ($20, OTC) are head and shoulders above the rest. Both operate in Japan.

Both are very international companies. In this disillusionment with technology generally, the valuations have come back enough to be of interest to us.

I think both of these companies will be much larger companies in real terms in five years than they are today.

In general, do you see a huge number of stock bargains out there, given the market’s slide?

Michaelis: There’s a lot more value relative to six months ago or a year ago. But I tend not to go to extremes; I don’t get too optimistic or too pessimistic. I’m trying to resist the temptation to spend my cash quickly.

I look for businesses where I have great confidence in the long term, and then I go in and accumulate the stock when other people are most pessimistic and sell when everyone is more optimistic.

Let’s talk about the selling part. You’re obviously a long-term investor for the most part. But some people are suggesting that the ‘90s will be more the trader’s decade than the long-term holder’s decade. In other words, you’ll have to be more disciplined about taking profits. What do you think?

Michaelis: That could well be. The message of the ‘80s was buy it and put it away. The message of the ‘90s is, if you get, say, a 40% profit, you sell it, or you sell some.

And you’re content to wait for that 40% over two to three years, but if you make it in just two or three months . . .

Michaelis: You get out.

What about stocks versus bonds now? I can earn 8.5% interest annually on a Treasury bond. Will stocks do that well?

Michaelis: On any long-term basis, stocks should do better than bonds. Now, over the next five years will stocks do better than an 8.5% yield? Probably, but it could be close. But you have to remember that, long term, bonds will not protect you against inflation. The reason to own stocks is to hedge against a collapse of purchasing power.

No doubt there are a lot of individual investors who agree with you about value in stocks, and about being patient. But what do you say to the person who really is terrified of economic disaster ahead?

Michaelis: If you’re really not confident, you shouldn’t be invested in stocks. And if you can’t understand the concept of return on capital, and you can’t read a balance sheet, you’re probably in trouble (in picking individual stocks). Most people probably are better off identifying a good mutual fund. It’s worth it to spend time looking for a mutual fund that meets your risk and return objectives.

I manage investments on the presumption that no one can predict the future. I just try to develop intelligent investment approaches based on possible assessments of the future.

You know, one big advantage individuals have over professional money managers is tremendous flexibility. People pay me to be invested in stocks for them at all times. For an individual investor, I think it’s reasonably easy to step to the sidelines and just come back later when the picture is clearer.

But remember that the market always goes up well before it’s clear that the problems are solvable.


The $300-million Source Capital fund, a closed-end investment company that trades on the New York Stock Exchange, posted a total return of 431% in the 1980s, beating the 402% rise of the Standard & Poor’s 500 index. Source’s stock was recently quoted around $36 a share.

The First Pacific Advisors fund family was ranked sixth best of 50 fund families in a long-term rating score sheet compiled for Changing Times magazine in September. The FPA funds are: two growth and income funds (Paramount, now closed to new investors, and Perennial), a growth fund (Capital) and an income fund (New Income).