I began my investment career as a stock analyst thinking that the index fund approach was lazy, willing to accept mediocre results. For the first 10 years of my career, I was a diligent and serious student of beating the market: Immersed in financial statements, industry competitive frameworks, and valuation methods. I studied successful portfolio managers to see who was winning against their benchmarks and how they were doing it. I learned, had some success, and my share of mistakes.
Evolve, Focus, and Face Reality
Periodic reviews of my results and those of top managers were mixed. Face to face with the data, I was forced to conclude if you want to beat the market, investing across many stocks in many industries wasn’t a winning formula because markets are efficient. Maintaining a consistent information edge over a wide number of companies is an exercise in futility. In order to win against the rest of the highly educated, 24/7 connected investment management industry, a change in approach was needed. A focus. An edge.
Buffet started as a pure, deep value investor, trying to buy stocks below book value. He later called this the “cigar butt” approach, meaning these were companies that might have one last puff! They were cheap for a good reason. His longer-term success began with an evolution in his thinking. He would buy only companies he understands, that have a “moat” or some competitive edge, and he would pay only a reasonable price. It’s a good approach. Simple but not easy because it requires being right about a company’s future prospects.
Competitive edge is a hard thing for companies to maintain and for analysts to decipher. Value correlates with competitive edge, or how that edge is perceived. In valuation theory, 65%-70% of business value typically is in the “terminal value” or long-term sustainable value. This assumes that a company can maintain a steady state against its competition in perpetuity, yet there’s never a guarantee that competitive edge will be sustained. Industry and global competitive forces, technological change, regulatory change, fraud, and poor management are a few key factors that can erode competitive edge.
The changes that occur regularly in the S&P 500 provide ample evidence that sustainability is a mighty challenge. According to Credit Suisse, the average age of an S&P 500 company is less than 20 years, down from over 60 years in the 1950’s. Today’s blue-chip companies don’t last as long they used to. It stands to reason that it’s more difficult for smaller companies to build and maintain a competitive edge.
The Edge: Industry Focus and Financial Acumen
I co-founded a technology-focused hedge fund in the wake of the dot.com meltdown along with two Silicon Valley veterans. Each with over 30 years of experience as engineers and executives. Our valuation and industry frameworks were comprehensive, informed by deep financial, technical, and product cycle knowledge. We knew our companies and their value chains very well. Focused, not diversified. That was the edge. We never held more than 10-15 stocks. After three years we were beating our benchmark. Still, we had a hard time raising money from institutions.
The experience in trying to raise money from institutions was enlightening. The reps came with their clipboards and said, “You must be different. Tell us about your process” They didn’t care about the process at all. What the majority really meant is you can’t be different, be predictable so we won’t make a mistake and lose money for our investors. The bottom line was even though our returns were good, our volatility metrics were higher than the benchmark. That was their chief concern.
Face to face with the data again. What’s the lesson this time? More return with more volatility is only popular when it works well. Maybe. In the right situation. Most investors, retail or institution, won’t wait to see what happens. Volatility is an accepted definition of risk and tends to be higher on the downside. People sell what they don’t know. In our fund, we thought we knew things the market didn’t within our portfolio. Investors didn’t agree with us. That’s the tug of war. It’s an uphill battle and slim odds of success, especially in public markets. Our focus, was their concentration risk.
Lessons Learned – Better Late than Never
The long-term evidence is very clear and consistent: 70%-90% of active managers don’t beat their benchmarks. The lessons from the Cowles commission studies in the 1930’s, multiple studies over the decades, and including today’s Dow Jones SPIVA reports reinforce that the odds of beating the market are small and they decrease over time. You may be able to hit a home run and find the next Amazon. And then can you do that consistently across an entire portfolio? That is a very slim probability. How many times will you strike out first? In addition to the Noble Prize work on the topic, Warren Buffet has instructed his Trustee to invest 90% of his money in index funds when passes away. Mr. Buffet is a a savvy insurance investor who knows the odds very well.
Contrary to my initial premise and that which Wall Street and the mutual fund industry sells, the index approach doesn’t produce mediocre results. In fact, evidence shows that indexing consistently delivers returns closer to top quartile. In 1975, Charles Ellis noted that fund institutions had come to dominate the market. In effect, they had become the market. Since 1975, institutions have become increasingly dominant. How can they beat the market when you add their fees into the performance calculation? In contrast, the index approach and its lower costs gives them an inherent and consistent edge in efficient markets. That trend has been recognized over the past several years as money flow trends validate.
The diversified portfolio approach makes sense for most people and institutions. And for good reason. There’s no guarantee in any approach with the stock market. However, a diversified approach with quality assets provides a discipline to rebalance (i.e. buy low, sell high, without trying to time the market), maintain a target risk/return profile that is client specific, and mitigates the risk of permanent loss if a Lehman Brothers or WorldCom goes down. This approach may not satisfy one’s speculative fever, but it will help you sleep better at night.
Alfred Cowles III, “Can Stock Market Forecasters Forecast?” Econometrica 1 (July 1933): 309-304
S&P Dow Jones Indices, SPIVA U.S. Scorecard, 2013-2018
Charles D. Ellis, “The Loser’s Game.” Financial Analysts Journal, July/August 1975; reprinted January/February 1995, p95-100
Jerry Matecun – Founder, President
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