Manager Selection in a World With Uncertain Forward-Looking Statements

The Sleeping Pill

One potential cure for the sleep deprived and a somewhat required reading for serious analysts is reading the SEC Form 10-Q of companies of interest. This is a disclosure document that details the past quarter and other periods of a publicly traded company. To make the document more useful to shareholders and/or perspective investors, the SEC requires a section called “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” This narrative gives the management a chance to explain in words what the numbers show or do not show. In order to dampen too much reliance on what is printed, there is a required additional (actually very long) statement entitled “Factors which could cause changes in the expectations or assumptions on which forward-looking statements are based include, but are not limited to.” At every investor meeting or analyst conference call reference is made to this disclosure.

Perhaps I read these turgid documents to repent for my sins as an avid follower of the mutual fund industry and a portfolio manager of a small private financial services fund.

The Nightmares

State Street Corporation is at the center of the mutual fund universe as the largest fund custodian in the world, the second largest manager of exchange traded funds (ETFs), a major provider of passive portfolio management and other services. With its impressive client base it should have a good view of the future for the investment business as well as itself. However, it lists 22 separate bullet points under its “Cautions as to Forward-Looking Statements.” In my opinion, 15 of these points are importantly under State Street’s control or at least heavily influenced by the bank. The seven that are not under State Street’s control or influence raise concerns as to the predictability of the future. I will briefly summarize them below:

1. The financial health (viability) of its counterparties as impacted by changes of law or regulation.
   
   
2. Financial market or economic disruption beyond “normal.” (To some this may be the “Black Swan” or “Fat Tail” risks.)
   
   
3. Not only the maintenance of high credit ratings, but also the level of credibility of credit agency ratings. (I believe a world without some informed credit ratings is a scary concern for all. Our fund is a long term holder of Moody’s stock.)
   
   
4. The level of redemptions and withdrawals from State Street’s collateral pools and other collective products.
   
   
5. The potential for new products and services that could cause the bank to be at operational risk and exposed to higher unreimbursed expenses.
   
   
6. Changes in accounting standards and practices. As we attempt to have a single global set of accounting standards, the accommodations to foreign issuers could cause harmful results to domestic issuers.
   
   
7. Changes in tax legislation, the interpretation of existing tax laws and the affect as to when tax payments are due.
   

The Implications

Perhaps it is very strange for me, who made money by analyzing and selling past fund performance data, to now consider State Street’s precaution that the past is even a worse guide to the future than it was in the past. The conservative management of State Street is suggesting that we should be warned that we are entering a new investment world. What this means to me is that reliance on past historic patterns could be dangerous to our wealth. Carrying this thought out, we should question the utility of various individual securities indexes like the multiple Dow Jones, Russell and Standard & Poor’s benchmarks. By definition many ETFs can become suspect of not capturing the new forces that operate within the markets.

The Exploiters

Many portfolio managers spend their entire investment life investing in the same securities. Some of these have good long term records, but that may not be of much comfort going forward if the pace of disruption accelerates. I would suggest that early general stock market investors who purchased Apple (which I own personally by historic accident) and Google after the flipping of the IPO phase ended, recognized change. Similarly, those global or international funds that were early in China showed the kind of sensitivity needed to ride the future waves.

How do you find these managers? I would suggest that it will be worthwhile to look at the new purchases shown in the interim reports. New names to the portfolio and perhaps new names for you are of great interest. Of course they have to go up in time to be very valuable. However, the willingness to buy into the unfamiliar can be a good trait, if on balance it leads to success.

A Search for New Names

If members of this blog community wish to suggest new names to me, I will be happy to publish a list with or without attribution and further comment in a future issue of this blog.


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