Chapter Nineteen

When Only a Specialist Will Do

How do you pick a money manager?

 

 

 

THE PURPOSE OF THIS BOOK has been to explain the tenets of value investing so that you can benefit from the investment strategy that has been shown to have the best long-term success. You may or may not choose the do-it-yourself route. If you have the time and the inclination to do your own investing, that is great. However, it is more important that you understand the principles of investing and know what questions to ask a possible manager or financial advisor. If you do, you can choose from the thousands of money managers for mutual funds who would be more than happy to manage your investments. Morningstar is a great service that tracks thousands of mutual funds. It breaks the funds down into style categories, shows performance, market caps, and examines the managers and explains their investment approach. Morningstar is not the final point in your search for the best money managers, but it is a good place to start.

Through the years, I have sat on the investment committees of various foundations and university endowments. I have had the opportunity to interview managers competing to manage a portion of the organization’s assets. Although I have often been the one competing for accounts, sitting on the other side of the table, being the interviewer, has been instructive, if not a bit more fun than being the interviewee.

The search for a money manager usually begins with an investment style choice. An investor—individual or large endowment fund—may want to add a value manager or a growth manager, someone who invests in large caps or small caps, and so on. Many large institutional pools of capital try to have managers who cover the spectrum of investment styles because different styles work better than others from time to time. If all styles are brought in under the investment umbrella, they hope not to underperform their peers or the broader market for any short-term period. My problem with this approach is that it reinforces short-term thinking. If you know one style does best in the long run, maybe you shouldn’t care about short-term performance comparisons. You also run the risk of building a portfolio that may look a lot like an index fund but with much higher costs. Better to go with an index fund and avoid all the management fees.

The typical money manager interview starts with a presentation of the manager’s style and capabilities, all of which are, of course, excellent. Then comes the question-and-answer part of the meeting. The questions are usually the same, as are the answers. Money managers are not dummies. They know what the client wants to hear. The first question is, “Do you do your own research?” Absolutely. No one ever admits to reading brokerage firm research. Hundreds, if not thousands of security analysts at big brokerage firms are producing reports that no one reads although some of this research can be quite good. Second question: “Do you visit the companies you invest in?” Again, the answer is absolutely, and money managers usually claim that they will only talk to the CEO or the CFO. This is cause for concern: Given the number of money managers demanding lengthy, personal interviews with corporate CEOs and CFOs, I have to wonder who is running these businesses. One manager I interviewed claimed to make 250 company visits a year. That’s one for every business day. Given travel time and the need for some sleep, when did this manager have time to read the annual reports? I have heard claims of 400 visits a year, and the all-time winner had a staff that made 4,000 visits. There isn’t enough time to read 4,000 research reports in a given year. The third question institutional investors usually ask is, “Do you have a succession plan at your firm?” The client wants to know who will take over if something happens to the money manager. Every money manager has a good answer but concern for my well-being aside, unless I or any other money manager is 80 or 90, the interviewer should assume we plan on sticking around for a while. Limiting oneself to younger managers or only those managers with detailed succession plans would have ruled out Warren Buffett as a manager option. Still would. Lastly, the clients always want assurance they will have direct access to the manager. Why not just watch what the manager puts in your portfolio and leave them alone to do what you hired them to do in the first place?

I have a different set of criteria that you can apply to mutual funds as well as individual money managers.

First, does the manager have an investment approach and can explain it to you, or any layperson, in plain English, and has the manager applied it consistently over time? If you can’t get direct face time with the manager, read all the shareholder letters and other promotional material published by the mutual fund for at least the past five years. Is it consistent in its approach to the market, or does the manager change horses midway through the race?

Second, what does the track record look like? Would you have been satisfied with the returns earned if you had been invested with them in the past? My preference is for at least 10 years of performance because that takes me through several market cycles. This is not always possible, but I would not go with less than a five-year record. It is also a good idea to note how volatile the returns have been. Some investors have a low tolerance for volatility, and you don’t want to be scared out of the market just when stocks are their cheapest.

Third, whose record is it? Does the manager who produced the returns that you find acceptable, still run the fund? Whenever a fund changes managers, you can often expect a change in the management style unless the new manager apprenticed with the former manager for a long time. I interviewed a manager who presented a 25-year record of investing in growth stocks. The record was pretty good, not great. My biggest problem was that the manager was only 36 years old, so unless he began managing the fund when he was 11, much of the record was not relevant.

Fourth, what do the managers do with their own money? Are they invested in the fund alongside the money you intend to invest? Managers should eat their own cooking, as we say. They should be willing to assume the same investment risks they are asking you to assume by investing in their fund. There is something comforting about knowing that managers have their own money on the line. It keeps them from taking undue risks if they hit a rough patch in performance.

While this is not always a true indicator, I prefer funds where the individuals running the fund are also the owners of the investment management firm. If the firm is run by mutual fund marketers and salespeople, they may have more interest in gathering assets than managing the money well. The marketing types also tend to be short-term focused, which puts pressure on the manager to make short-term investment decisions that may not be in your best interests. Money managers who also own their firm are freer to make long-term investment decisions, as only a client can fire them. These managers just have to convince their clients to stay around during some period when relative performance lags.

The secret to winning in the investment business is to pick good managers and stick with them.