As has been noted on this blog and my book, MONEY WISE, which is about to go into paperback, I believe that each major investment need should have a separate set of investments. The end game for all investing is to produce capital for eventual spending. In many cases, the time frame for charitable institutions and wealthy families is infinite. Investing through mutual funds and hedge funds is not necessarily the best single way to invest, but it is far from the worst. Due to my background of studying funds for the last 50 years or so, funds are the first choice in my investment tool set.
To accomplish the goal of providing for future spending needs, one is essentially dependent on the current spending rate and the growth of capital as they pass through the filters of inflation and taxes. Like most all other investors, I am predisposed to the term “growth.” One of the ways to grow capital is to invest in growth stocks, often found in growth funds.
As someone who has probably created more fund classifications than any other individual, I recognize that turning fund classifications into investment objectives was never designed primarily to help in fund selection. The beneficiaries of classifying funds into peer groups include fund portfolio managers, independent directors of fund groups, owners of fund management organizations and the fund marketing systems. In essence, fund classification produces bragging rights. Particularly in the developed world’s competitive focus, ranking against peers becomes the title requirement for ownership of bragging rights. This is exactly where a dichotomy lies between the needs of a fund investor and the above-mentioned beneficiaries of fund classifications’ bragging rights.
To keep the reward game honest, a set of rules are needed which should be based on empirical evidence. For example, my old organization, now known as Lipper, Inc., defines a growth fund as a fund that has a price/earnings ratio greater than the S&P 500, and a three year average growth rate of sales per share that is above the same broad market indicator. Others use some variation of high price sensitivity and historic trend analysis. Note that all of these measures are backward looking because they are known and are usually not adjusted for post-period recognitions of material differences.
One of the sound arguments against using any broad market securities index is that you are paying for past successes. Remember the SEC requirement that is meant to go with any performance advertising: that past performance is no guaranty of future performance. As a matter of fact, after prolonged periods of specific progress, the mathematical pull of regression to the mean becomes overpowering. Leaders give up the performance leadership and often become laggards, while laggards become leaders. Usually at some point in a sales pitch for a fund, reliance is placed on the fund classification bragging rights mentioned above.
Extrapolation is easy, particularly if one sees no imminent signs of major reversals. Instead, I am addicted to anticipation. I think about the uncertain future. I have a preference for managers who are also searching the future to find stocks that do not represent an extrapolation of the past. This is much more difficult. In the mid- 1960’s a very good analyst caught the shift from a cyclical valuation to an expected growth valuation for a, now much smaller, company named General Motors. His market call worked for a while until it became accepted word near its cyclical peak. Think about IBM, which started life with more water in its balance sheet than assets. For many years, IBM was considered a growth company; then it became an income stock and now is a consulting services company. Imagine the problems of keeping IBM within any giving index as a predictor of future price behavior.
After a long period of declining prices, the best relative performances are held by those funds that exert a tight price discipline and/or have used cash as a significant investment. Many of the best, well known, investors have used this type of “value” oriented approach. For investment needs where the spending rate is high relative to the earnings rate, these price disciplined investments should play a major role. However for some needs (particularly in the early stages of many portfolios), the growth of the long term capital is of greater importance than the annual total return generation. Growth of capital is also a primary driver for many wealthy families, who believe the current level of capital is insufficient to meet future generational and /or philanthropical needs.
By dividing one’s resources into need-focused portfolios, one may have the best of both worlds (value + growth). Periodic rebalancing between the portfolios should be driven by the changing levels of needs. As the late Sir John Templeton would direct, changes to the individual portfolios should be made on the basis of focusing on better bargains. These bargains can be in future growth stocks or funds.
The successful selection of future growers is difficult, at best. In my case it is achieved by listening to smart managers that have different points of view based on their own research methods. As noted previously, I am willing to own funds that have different, and in some cases conflicting points of view.
Do you agree?