The Art of Manager Selection

More than ever, investors are bombarded with hundreds of advertisements, that pitch different investment products or money managers. Picking among these thousands of alternatives can seem an impossible feat. In this paper, we explore an “intellectual village” put forth by Warren Buffett as one of the most successful and repeatable methodologies in the history of investing. The primary conviction from this school of thought is that assets should be bought only when their price is a fraction of a reasonably calculated value, ignoring everything else.

The Problem

Investors are often frustrated by a lack of clarity when it comes to picking particular money managers for different parts of their portfolio. They usually pick “who has been doing well” only to watch that manager not only lose value on an absolute basis, but even lag his peers. Or months after their funds stop performing; they realize too late that the firm has changed managers on them.

Given the industry’s merry-go-round of fund managers, funds merging, closing and opening and performance being so fleeting, how do you pick the best option for you from thousands of alternatives? For many investors, doing so can cause extreme frustration.

One school of thought says to just give up and buy index funds. Although these investment vehicles are certainly cheap, investing in them is a far-from-perfect solution. Most indexes are market-cap weighted; this means the higher the value of the firm in the market (read “potentially overvalued”) the bigger the weight it is given in the index. This is why the highest sector weighting in the S&P 500 in 1999 was technology and in 2007 was financials. Essentially, this means that index funds invest where everyone else is investing most heavily at any given time. As a colleague of mine once put it, “Indexes invest like drunken sailors.” This sentiment is not entirely untrue, as indexes have a severe momentum and growth bias.

Although indexing certainly has inherit problems, several academic studies demonstrate that, due to high costs, indexing still beats the majority of actively managed programs on an after-tax, after-fee basis.

Early in my career, I found selecting managers a puzzling task. Then, one day, I stumbled upon a speech given by Warren Buffett in 1984 titled, “The Superinvestors of Graham and Doddsville.” That single speech changed my viewpoint such that this puzzle became a workable problem for me.

The Solution

In his speech, Buffett starts with a thought experiment that goes something like this: If one holds a national coin flipping contest, in which he asks 225 million Americans to predict coin flips accurately, after 20 days, there would only be about 215 people left in the competition. These people would get pretty cocky about their ability to call a coin toss, until some math professor became rude enough to point out that 225 million orangutans flipping coins would get the same result. But now, suppose out of the 215 winning orangutans, 50 came from the same zoo…you’d be pretty sure you were on to something. Likely, you would go to that zoo and ask the zookeeper what he’s been feeding the winning orangutans, what exercises they do and who knows what else.

Like the orangutans, what Buffett and his cohorts were “fed” was a methodology handed down by Benjamin Graham and David Dodd, generally considered the fathers of value investing. Buffett calls this common “intellectual village” Graham & Doddsville.

Buffett goes on to profile nine of his peers from that village, who had multiple decades of superior investment performance. It is important to note that these men were only “fed” a similar school of thought as Buffett, they were not picked with the benefit of hindsight by him after the fact.

At the core of the value investing philosophy is finding a discrepancy between price and value. To paraphrase Buffett:

The common intellectual theme of the investors from Graham & Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market. They exploit this discrepancy and don’t care whether stocks are bought on Monday or Thursday, or whether it is January or July. Incidentally this is the way businessmen buy businesses. Our G&D investors do not discuss beta, CAPM, charts or covariance in returns among securities. Can you imagine buying a whole business because the price of the business had been marked up substantially the week before? These are not subjects that interest them. These investors simply focus on two variables: price and value.

It sounds so simple, and it is simple…but that doesn’t mean it’s easy. Especially the part about not being distracted by the multitude of other things you can pay attention to, not least of which is the Internet/TV information overload.

Through my extensive readings of legendary value investors, I picked up on some common traits that most of them employ. Value investors…

… Distinguish Between Investing and Speculating

In the sequel to Wall Street, the notorious Gordon Gekko states, “Speculation is the mother of all evils.” And for once, I agree with him. But how do you make the all-important distinction between investing and speculating? I have struggled with this distinction for years, as it is a subtle, but incredibly important nuance.

Benjamin Graham defines investing as “an investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” Thinking about Graham’s words and others for a long time, I eventually settled on my personal definition:

An investment is an asset whereby using conservative assumptions about the future, one can expect the asset to generate enough cash to ensure a satisfactory return for the perceived risk taken — e verything else is speculation.

When I say “cash return,” I don’t mean a stock price going up and the investor having more cash, I mean the firm (or other asset) itself is generating cash and either paying it out as dividends, stock buybacks or reinvesting it in the business to compound the value of that asset. As Bruce Berkowitz says “follow the cash,” for it is the only way to be sure value will exist at some point in the future.

In considering what distinguishes an investment from a speculation, it is important to note what the distinction excludes, such as purchases with the hope of selling to a greater fool. For example, many “investors” looked like geniuses in the late 90s as nearly everything anyone touched turned to gold over a period of many years. But once the technology speculating ended, many of these genius “investors” were left penniless and lives were shattered.

Carefully distinguishing between investing and speculating also means that investing in non-cash generating assets—such as gold—is, at least by my definition, speculation. Think about it, what gives gold its value? The cash flows from gold are negative: you have to mine it, store it, transport it, insure it, etc…The only thing that gives gold any value is the fact that someone else is willing to pay for it. So an investment in gold is largely speculating as to what other people will be willing to pay for it at some point in the future.

A corollary to my definition of an investment is, if you invest in individual stocks and you are not intimately familiar with its financial statements, free cash flow, discount rates, strategic value drivers, etc…then all of your stock picks are speculative. This is fine for a Vegas-type thrill but woefully inadequate if your portfolio is expected to fund an important life goal, like your retirement.

… View Risk as Permanent Loss of Capital

Most managers are hired, fired and compensated based on how they perform relative to an index. But how ridiculous would it have been to measure yourself against the S&P 500 in 1999, amidst a stratospheric bubble? Yet most money managers did and do take their index as the “neutral” position and go from there. By and large, they’re not to be blamed for taking this faulty position, as that is usually how they are measured and compensated. However, if you consider this line of thinking carefully, it is clearly quite insane.

Unlike their peers, value investors view risk as a permanent loss of capital. Permanent loss of capital is more about the value of an investment than it is about its price. This is what allows volatility to be the value investor’s friend. To illustrate, consider a hypothetical firm that—based on your diligent research—you are convinced is worth $100 per share. You see its stock price go from $100 (not a bargain) per share, down to $90, then to $80, and then a panic really hits and its stock all of a sudden begins trading at $50 per share. Wouldn’t you start salivating? Getting more and more excited as the price went down? This means you could buy an asset that you have high conviction is worth $100 for only $50…that’s the best deal in town! This is exactly the core of value investing.

And this is why Buffett says, “My enthusiasm for stocks is in direct proportion to how far they go down.” The problem is a lot of investors, including fund managers, haven’t done their homework and don’t have enough conviction in the value of the assets they are investing in. As a consequence, they have the opposite reaction; they panic as prices drop and raise cash as the market gets cheaper.

In circumstances like the above, even when prices exceed our theoretical $100 intrinsic value, these investors stay fully invested, because they fear they will fall behind their peers. This sort of shortterm relative race is nonsense and it is ultimately responsible for a large part of the mediocre returns in the asset management industry.

… Are Willing to Hold Cash

Cash can be a valuable investment at times. Think of it this way, if not forced, would you ante up in a game of poker when the odds are not in your favor? In investing, there certainly are times when the odds are not in your favor either. You don’t have to play the game at that point; it would be foolhardy to ante up at these times. Buffett uses a baseball analogy, explaining that investing is like a baseball game in which no strikes are ever called. You can just sit at home plate and wait for the perfect pitch. In this case, only those with the fortitude to say, “Nothing meets my investment criteria today; I’ll wait until tomorrow and look again” will avoid eroding their discipline. This is why the great investors have been known to let massive amounts of cash build up in their portfolios. When the masses are overly optimistic, there simply may not be very many attractive investments out there.

… Have a Demonstrated Ability to Go Against the Crowd

Morningstar’s manager of the decade, value investor Bruce Berkowitz’s slogan is “Ignore the crowd.” A highly attractive investment sought by the “crowd” almost, by definition, will sell at a premium. A sound value investor avoids these assets, searching instead for “out of favor” assets that offer good value and are, by definition, cheap. Applied appropriately, this philosophy will nearly always steer capital away from bubbles and into better-valued firms.

… Are Willing to Use Time Arbitrage

Value investors are willing to use time arbitrage; investing in what has value for the long-term and ignoring potential short-term swings. James Montier said it best:

Exploitation of the fact that most investors – institutional, individual, mutual funds or hedge funds tend to have very short-term time horizon, have a rapid turnover or are trying to exploit very short-term anomalies in the markets. Thus the market looks extremely efficient in the short run. In an environment with massive short-term data overload and with people concerned about minute-to-minute performance, the inefficiencies are likely beyond one year.

In fact, many legendary value investors have much longer time frames and seek to hold a firm’s stock 5-10 years after they purchase it.

… Concentrate Their Holdings

To paraphrase Buffett: nobody ever got rich on their 14th-best idea. Many fund managers who index to the S&P 500 have 200 stocks in their portfolio with a maximum allocation of 2.5% to their top holdings. This means, they own 40% of the index and have to keep track of 200 firms! Historically, the best managers make significant bets when they see a high conviction opportunity. There just aren’t enough good deals out there to invest only 2.5% of your capital in your favorite one.

Buffett is famous for telling MBA students that they would become much better investors if they had a punch card with only 20 circles on it; once the punch card was used up, they wouldn’t be able to invest in any more assets. The intuition behind this idea is simple: be patient and wait for a few great ideas. Then, invest a significant amount of money when you find one and hold on to it for a long time. Too many people invest in too many assets casually, mistakenly thinking that “diversification” is a panacea for not doing your homework, ignorance or speculation.

“What about diversification? If I buy and hold only a few great stocks, aren’t I putting all my eggs in one basket?” In his poorly titled, but fantastic book, “You Can be a Stock Market Genius,” Joel Greenblatt breaks down the statistics on diversification—and you might be surprised at the result. He states, “After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small and; overall market risk will not be eliminated merely by adding more stocks to your portfolio.”

Imagine the human cost in terms of attention to detail and monitoring capabilities if a manager holds only 30-40 stocks in his portfolio versus one who has 200! From an investor’s standpoint, everyone should be diversified in at least a few asset classes, so even if you just owned the big 5 (That is, large, mid and small caps, international stocks and bonds) and each manager has an exceptionally concentrated portfolio of just 30 securities (which almost never happens) then you would own a total of 150 securities. This means in an evenly weighted portfolio, if one of your manager’s picks falls to zero, it would mean a .66% loss to your portfolio! Wow, that’s scary! Compare that to constantly owning dozens of securities that aren’t your manager’s highest conviction picks. Ultimately, diversification is like alcohol, it should be consumed in moderation.

… Are Willing to ‘Eat Their Own Cooking’

How much a manager has invested in his own fund can be a useful barometer of his belief in himself/herself and the strategy. A recent Morningstar study found that about half of the mutual fund managers tracked have NONE of their own money in the funds they manage. ZERO. Compare this to Buffett, who has almost his entire net worth invested in Berkshire Hathaway. In fact I can’t even think of a single one of the “greats” who didn’t have a substantial portion of his or her net worth invested in their own fund. Fairholme, Longleaf, Hussman funds all have manager investments in their funds to the tune of tens—if not hundreds—of millions of dollars.

Do you want a manager whose attitude is, “Do as I say, not as I do?” Or, do you want a manager who essentially says, “I’m going to stick by your side during the ups and downs, whatever my performance, we are going to experience it together.” This is no-brainer, isn’t it?

If It’s So Great, Why Aren’t More People Value Investors?

One reason is lack of conviction; it took me 10 years of experience and study, reading the right books and going through more than five years of post-graduate education (a lot of that time I spent learning how not to invest) to develop an absolute conviction that value investing was the right way to do things…through and through.

Another reason is lack of patience. We live in an instant gratification world, when a portfolio underperforms the “drunken sailor” indexes, we want our managers to go do something about it— do something different, something aggressive so we can start “winning” again. Unfortunately, intelligent investing isn’t football. It’s not a sport where a “win all the time, at any cost” attitude gets you anywhere.
To invest intelligently you have to allow for the speculation hares to outrun your fundamentally sound turtles … often.

During the speculative tech stock super-bubble, many managers, even some with some long-term successful track records, were fired (only to be scooped up by smarter firms). Even Buffett was attacked in the press as a “grandpa” who just didn’t understand the “new economy.” It only took until 2003 for Buffett to be the one left laughing. Easy to see in hindsight, but for every fund manager with a boss or investor wondering if he or she was doing the right thing, it seemed like an eternity before value investors were able to redeem themselves.

Staying this course can take a painfully long time. During the tech bubble, this took as long as five or six years. But as Jeremy Grantham said, in what has since become one of my personal favorite quotes:

“I’d rather lose half of my clients than half of my clients’ money.”

So why not speculate and switch over to value investing just before things turn sour? Buffett has a good analogy for this too. To paraphrase him: “It is a lot like Cinderella at the ball…everyone is dancing and having fun and they all think they’re going to get out two minutes before midnight…only there are no clocks on the wall.”

Finally, value investors are usually early in their purchases as they invest when valuations fall to their target prices. Of course, manic-depressive markets usually revert beyond the mean, causing value investors to look dumb for a while.

Does Value Investing Still Work?

It is interesting to note that in any given year (or two or three years, for that matter) value investors may not be at the top of anyone’s performance list. But if you look at the most recent winner and four runner-ups for Morningstar’s “Domestic Manager of the Decade,” four of them would consider themselves value investors (the fifth may too; I just don’t know his philosophy well). Even Buffett and Munger, who manage an excessively difficult amount of money, still managed to compound their capital at an impressive rate during the first decade of this century.

What Value Investing Means to You

If you are a do-it-yourselfer, you can use these attributes for value investing as a general framework to help you pick the kind of managers you would need for certain portions of your portfolio. For example, if you are looking at a mutual fund in which the highest weighted stock is 1.8% (theoretically, the highest-conviction pick) for the fund, then run. If you see a manager on TV and he says he’s invested in a company “for the long term” but then defines the “long term” as 12 months (I actually heard this a few days ago!) then run. If you find a manager who has no personal investments in the fund he manages then run.

If you’re not a do-it-yourselfer, then find yourself an advisor who believes in the value philosophy. When interviewing an advisor ask them what philosophy they subscribe to and compare that to the philosophy of the great value investors. Finally, the most important thing you can do is understand the “why” of performance. Whether you are a do-it-yourselfer or are going to hire someone to do this for you, there will be periods of underperformance. Understanding why a manager or portfolio is underperforming is critical. If you have hired an advisor and that person can’t tell you why one of the funds in your portfolio is underperforming, that probably isn’t a very good sign.

Remember that there are perfectly good reasons to underperform, just as there are bad reasons to outperform. For example, loading up on stocks in an industry that has strong momentum, but high valuations and bad fundamentals is a bad reason to outperform. Some good reasons to underperform are not partaking in a speculative rise in an industry or the overall market. Sometimes great investments just don’t move for a long while. These are all good reasons to lag peers.

How many people, if on a golf course with Jack Nicklaus or on a basketball court with Michael Jordan would ignore a piece of advice? Yet, just like these super athletes, we have this great pool of super-investors: Buffett, Munger, Klarman, Berkowitz, Greenblatt, Einhorn, Graham, Hawkins, Pabrai, Schloss, Whitman, Eveillard, Cunniff just to name a few, who all share a similar philosophy and yet the majority of the world chooses to ignore them.

As Buffett said, “It baffles us how many people know of Ben Graham, but so few follow. We tell our principles freely and write about them extensively in our annual reports. They are easy to learn. They should be easy to follow. But the only thing anyone wants to know is, ‘What are we buying today?’ Like Graham, we are widely recognized, but the least followed.” Ignore at your own risk!