FOOL ON THE HILL
A Different Kind of Broker

While a skeptic of most brokerage houses, Whitney Tilson is impressed with one that has a long-term, low-turnover investment philosophy and truly puts its clients first.

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By Whitney Tilson
December 11, 2001

Quick! Name the only major brokerage house that didn't drink the dot-com Kool Aid. That didn't participate in any IPOs of ridiculous, worthless companies whose stocks soon went to zero. That refused to offer online trading. That in November 1999, near the peak of the tech stock bubble, sent 2.3 million letters to every one of its clients warning them about "investors' increasingly unrealistic expectations regarding the future performance of the stock and bond markets," and noting in particular "a great deal of risk in the 'dot-com' fad."

Give up? The answer is Edward Jones. Never heard of it? Neither had I until I had the opportunity to spend three hours with its managing partner, John Bachmann. After meeting him and doing some research on the company, I'll confess that I'm an unabashed admirer.

Background
Edward Jones was founded in 1922 and has grown to become the seventh largest securities firm in the United States based on number of brokers (approximately 8,400 at latest count, growing by four a day, with plans to hit 25,000 by the end of the decade). The firm is enormously profitable and successful. Since Bachmann assumed control in 1980, it has grown its top and bottom lines at an annual compounded rate of 23% and consistently generates pretax margins and returns on equity of at least 10% and 25%, respectively, significantly above the industry average. My only regret is that it's not a public company, because I'd love to own the stock (at the right price, of course). (Incidentally, the firm has had buyout offers of up to 10 times book value, but is steadfast in its desire to remain private and independent.)

Edward Jones has such a unique, focused strategy that the godfather of strategy, Harvard Business School Professor Michael Porter, wrote a case study on it. The key elements of the firm's strategy include an entrepreneurial culture revolving around small offices staffed by only one broker (plus an administrative person), an emphasis on long-term, low-turnover investing, and a strong focus on rural areas (though 70% of brokers are located in metropolitan areas) and on average American investors (the average account size is about $50,000).

Edward Jones vs. the big brokerage firms
I have long had a dim view of the major brokerage houses, feeling that in far too many cases they:

  • Are conflicted due the many lines of business they're in. For example, if a firm's investment bankers are taking a company public, guess what the brokers will be selling that week -- even if the investment is risky or speculative and might not be appropriate for most clients? And if the firm has its own line of mutual funds and other investment products, guess what the brokers will be biased to recommend?

  • Are willing to sell (if not outright push) aggressive investment products like options, commodities or penny stocks on na�ve or greedy clients.

  • Are especially prone to sacrifice clients' interests at the end of the quarter so they can meet earnings estimates.

  • Lack a clear investment philosophy, resulting in the endless chasing of fads.

  • Try to time the market -- and do it badly (e.g., they are bearish at market bottoms and bullish at market tops).

Edward Jones's strategy is to be precisely the opposite. In particular, the company:

  • Does not have any in-house mutual funds or any other proprietary products.

  • Does not sell options or commodities, rarely recommends IPOs, and does not pay its brokers for trades of over-the-counter stocks with prices below $4.

  • Has no pressure to meet earnings expectations since it's a private partnership, not a public company.

  • Encourages its clients to have realistic expectations, focus on the long-run and ignore the short-term vagaries of the market. As a result, its clients hold their mutual funds an average of 20 years, far more than the 3-5 year average for other brokerages.

  • Recommends only high-quality stocks and then sticks with them. Of the 15 major brokerage houses whose stock picks are tracked by The Wall Street Journal, Edward Jones had by far the lowest portfolio turnover (less than 15% annually), and by far the highest returns over the past five years (through 9/30), at +85.1%. (The next highest was Merrill Lynch, at +64.9% -- the only other firm to beat the S&P 500's return of +62.7%.) Blue-chip stocks + low turnover = market-beating returns. Coincidence? I think not.

I'm not trying to paint a black-and-white picture here. I'm sure there are some incompetent or unscrupulous brokers at Edward Jones, and most brokers at other firms no doubt care about their clients and serve them well. But I believe Edward Jones has an investment philosophy, corporate culture and structure that makes it uniquely and exclusively focused on its clients' best interests.

This belief is confirmed by an independent survey last year by Registered Representative magazine. In it, eight firms' brokers were asked to rate on a scale of 1-10 their own firms in a variety of areas, and Edward Jones consistently scored at or near the top. On the questions I believe are most important, "Freedom from pressure to sell certain products" and "Overall ethics of the firm," Edward Jones had the highest scores of 9.96 and 9.98, respectively (the averages were 9.08 and 9.23 and the laggard firms were Merrill Lynch at 8.26 and Prudential Securities at 8.60, respectively).

Case study on strategy and corporate culture
I've written a number of columns about strategy and corporate culture, and how critical each of these elements are in building and maintaining competitive advantage. Edward Jones is one of the best examples I can think of in which a small company in a highly competitive industry has been able to generate significantly above average growth and profits due to a distinct, focused strategy and powerful corporate culture.

Conclusion
Perhaps it strikes you as unusual to read an article on this site that speaks favorably about a brokerage firm. After all, The Motley Fool in many ways stands for investors rejecting stock brokers and instead taking control of their financial lives and making investment decisions on their own. I believe this is good advice for many people, but the more I talk to average individual investors, the more I realize that many other people simply don't have the time, interest, or ability to manage their money (see my column, Get Help, If You Need It).

This has always been true, even at the peak of the online stock trading mania early last year. Thus, it's entirely reasonable that many people would hire a stock broker or other financial advisor to assist them. I'm not recommending that you rush out and open an account with Edward Jones by any means. The capabilities and integrity of the individual broker are undoubtedly more important than what firm he or she works for. But a firm's investment philosophy, corporate culture, and structure are also critical for investors looking for a broker, and I believe Edward Jones rates highly in these areas

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He did not own shares of any company mentioned in the article at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/