In last week’s post we discussed the questions that arise from examining turnover rates. Most fund selectors are concerned about too high of a turnover rate. They are worried that these funds basically rent positions in the stock and are only in “the name” for a relatively brief period — not for the longer-term profit generation from growth of the underlying issuer. Another consideration is that the costs of transactions, including spreads between actual transaction prices and the pre-transaction bids, eat into the profits of ownership, particularly when appropriate after-tax costs are considered.

After a series of visits over the last year with managers who adhere to something of a value discipline (even though a few claim to have a growth orientation), it was stated that there was a risk that some turnover rates are too low. Their portfolios go for years with a number of investments that don’t work out. Often these securities do not totally collapse in price and may eventually go up to a perceived value price. What is not taken into consideration is the opportunity cost of not having winners, or at least market performance, during the elongated holding period.

Warren Buffett’s bad lessons

Many investors, analysts, and portfolio managers focus on the writings of the two great names in our pantheon of analytical thought: Ben Graham and Warren Buffett. We are guided by their words and not what they actually did or do. Many believe what Warren Buffett at Berkshire Hathaway* stands for, which is buying good companies at reasonable (not cheap) prices and holding them forever. Remember that Buffett closed his successful hedge fund to use his own capital to buy a failing textile business at what he thought was a cheap price. (This flirtation with bankruptcy is similar to the absolute need to fire Steve Jobs from Apple* in 1985.) Luckily for Buffett, soon after that experience of being an operating entrepreneur he got hooked up with Charlie Munger, who taught him to buy good companies with good managers and let them manage all of their companies (except capital allocation, in which he became an expert). The biggest advantage that he had was that he could invest the leveraged float created by his wholly owned insurance companies. These dollars were used to buy other operating companies who had unique and strong competitive positions at currently reasonable prices. With the excess dollars he built a portfolio of investments; some proved to be short-term, like airlines or high-income investments that took advantage of distressed situations, which would be paid back quickly if the companies survived (Goldman Sachs,* General Electric, etc.). In his large-cap portfolio he was able to buy shares of American Express,* Coca Cola, and Moody’s.* He is selling Moody’s after seeing that it has become a much stronger company. His two relatively new internal managers have a much more eclectic appetite and are accustomed to higher turnover rates.

I can’t play the same game because I don’t have some of Buffett’s advantages, like a generally growing float and the ability to hold wholly owned companies at historical purchase prices.

Mutual funds and other performance-oriented accounts are measured differently

While mutual fund marketers and regulators try to focus present and future potential investors on various time periods of 1, 5, or 10 years and since inception, the daily prices of funds drive toward different time period considerations. Any given day can be a peak or bottom of an important trend which should be measured. The change of portfolio manager or investment approach could cause a reappraisal as to what are ongoing significant time periods. Most important of all is the relative performance of competing funds for investors’ dollars. In each period, the relative performance of individual securities takes on different aspects in a portfolio’s overall performance. A stock price that is flat in a downturn is positive to performance, whereas the same flat performance is a negative in a rising market.

The classical way to teach analysts

Analysts trained academically (including through the CFA exams) or by large organizations are taught to find and promote good companies particularly with so-called moats (impenetrable competitive positions). Oftentimes these “good guys” are preferred regardless of price and without any significant attention to disruptions in the economy, market, or sector. As analysts and portfolio managers get older, the attraction to these “good guys” become greater because so many lesser lights have failed as stocks. Soon the portfolio is a collection of surviving “good guys” and the other positions have been liquidated. I am sympathetic to this condition, as my personal portfolio is disproportionately invested in these collection pieces. Luckily for my clients, a price/value discipline keeps both “good guys” and cheaper (and hopefully more potentially promising) investments in their portfolios (particularly of funds).

Most funds are managed by analysts

Most funds are managed by analysts, though in many cases they also have direct analytical responsibilities. In most cases, the portfolio manager views her/himself as a super analyst and spends the bulk of his or her time going over and sharpening the analytical views expressed. All too often, analysts stubbornly believe in the models that produced their list of “good guys” regardless of what the current market is saying. The super-analyst-portfolio-manager having the same training and attitude as his analytical staff goes along with their views, and hence the portfolios take on the aspect of a collection instead of a vehicle addressed to the current market.

The further training of portfolio managers

I maintain that simply being a good analyst is not enough to be a good portfolio manager. The PM needs to understand the current and likely future markets; this is learned by spending time with good marketing people as well as good and bad investors. The PM has to learn how to use his trading desks not only to get the correct executions but also as a source of market and competitive intelligence. All PMs should study competitive portfolios and performance, not to copy them because the student will be late. The key is to understand how the competitors reacted to presumably the same information that she/he received; given that perspective, what are their likely actions in the future based on different scenarios? PMs as operating officers should be concerned with the development of analysts, traders, and administrative people, including the compliance forces. The PM should start to anticipate changes in direction for her/his own firm. I believe there is a lot more to being an effective portfolio manager than being a super analyst.

In summation

I believe that stubborn analysts can lead to stubborn portfolio managers who, like a stopped clock, will only be correct twice a day (or once in the military). The portfolios will not be in a winning position most of the time. I worry when I see a poorly performing fund with low turnover rates that we could be experiencing one of the biggest untaught risks in portfolios: stubbornness.

How do you correct for your own stubbornness?

Please share with me, for it is an ever-present danger in being attracted to “good guys.”

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^*Some shares are owned in our financial services private fund or personal portfolios.