Handicapping Mutual Funds the “Belmont Way”

As many of our blog community members and readers of my book, MONEYWISE already know, I credit the US Marine Corps and the racetrack as my two great educational experiences; as distinct from Columbia University, from which I graduated. What little I know about security analysis and mutual fund selection is based on what I learned at the race track.

For those who have a detail orientation and are comfortable with basic arithmetic, the task of analyzing races is a great challenge and a pleasure. Just some of the items to take into consideration are the track records of the horses, their parents, the trainers and the jockeys. These factors are vital in terms of the winning results, but more importantly, the conditions under which the records were produced. The objective of all this study is to pick net winning bets, (winning more dollars than losing). Note by setting this goal I am accepting the reality that a number of the bets will be losers. I do not expect to win with every bet. I carry this expectation into my investing in funds and individual securities.

The Belmont

Belmont Park is America’s longest dirt race track. Each year in June it conducts the Belmont Stakes, which is the so-called third crown of the Triple Crown for three year old colts and fillies. Linking the three races into an overall result is a public relations/media concoction and has very little to do with the development of racing and perhaps more importantly, breeding results. No single horse has won the three races since 1978. Out of the last twenty-three years there have been eighteen years (including this past Saturday) that neither the winners of the Kentucky Derby nor the Preakness Stakes have won the Belmont.

As a kid who grew up in New York City, I have always taken the attitude that the Belmont was the real test of champions. Further, as the race normally has the fewest horses and the longest distance, it is the truest race. (Most of the horses will not run again at a distance of a mile and a half in the US.)

The Analytical Bridge to Fund Selection

Picking winners at the track, called handicapping, involves a great deal of intensive research and analysis. With all of this effort, the odds are that I will come up with more losers than winners; but by limiting my wagers to selected races and appropriate odds, I will come out dollars ahead. Many of the same techniques that I use in the search for winning horses I use in selecting funds for my clients and myself. There are two big differences in investing in funds. The first is that a losing race ticket is worthless, but when a fund goes down all is not lost. The second is with a race the most important result is at the predetermined finish line. With investing it is a continuous race which ends when the investor chooses, except if it’s a forced sale due to external circumstances, e.g., better bargains, change of objective, a margin call or similar involuntary termination.

Belmont Lessons and Fund Selection Applications

I have spent almost my entire professional career of more than fifty years thinking about investment selection. I use many different inputs for my analyses. The purpose of the following exercise is to show the application of the lessons observed from this year’s running of the Belmont Stakes to fund selection as well as examining the use of specific past performances to correlate to future results. The objective of the exercise is to improve the odds of avoiding losers and picking some better than average results. The following list outlines the lessons from the Belmont Stakes, and their applications to fund selection as a point of departure for deeper analysis:

Belmont Lessons matched with Fund Selection Applications

• The 2011 Belmont race was very slow by historical standards. Fund winners in a given year have had gains of 100%+, to losers of (-50%), with the norm of 8-12%.
  
  
• Too many horses crowded the favorite from the gate. Too many investors plowing into the same names at the same time makes it difficult to get a distinctive advantage.
  
  
• Racing luck=Derby winner losing early contact with its stirrup. Anything that distracts portfolio managers in their personal or professional lives could be a factor.
  
  
• Change of equipment: first time use of blinkers by the winner. Some PMs need to focus more
  
  
• Winning change in strategy from stalking to being near the lead. Adapting to change conditions
  
  
• Performance records not useful. Managers of the year or decade can lose

Ten Past Bull Market Winners

Each week I look at lists of funds that are of interest to our clients. They either own these funds or are considering them. We compare the funds with their own specific peers and array them in quintiles. Recognizing that often fund performance fits into a bell-shaped curve, we include funds that are in the three highest performing quintiles. The following is a list of funds of interest for one of our clients. The list includes funds that performed in the top three quintiles in the rally between March 31, 2003 to September 30, 2007. Next to each fund name is its quintile performance in the current rally which started on March 9, 2009 and continued through June 2, 2011.

CAUTION: ANY FUND MENTIONED IS FOR FURTHER RESEARCH PURPOSES AND IN NO WAY SHOULD BE VIEWED AS A RECOMMENDATION.

• Mutual Global Discovery - Fifth quintile. Portfolio Management changed
  
  
• Templeton Institutional Foreign Investment - Second quintile. Good in down markets
  
  
• CGM Focus - Fifth quintile. Poor in down markets
  
  
• Longleaf Partners - First quintile. Poor in down markets
  
  
• T Rowe Price Growth - Second quintile. Third quintile in down markets
  
  
• Dodge & Cox Stock - First quintile. Poor in down markets
  
  
• Vanguard Mid-Cap Index - First quintile. Poor in down markets
  
  
• Thornburg Value - Second quintile. Poor in down markets
  
  
• Fairholme - Third quintile. Financials lag this rally
  
  
• Vanguard Small-Cap Index - First quintile. Poor in down markets

The superior performance of the two Vanguard index funds suggests that the index funds are not structured or own the same securities as their actively managed peer funds.

One of the lessons from observing the Belmont Stakes is that some of the participating teams of horses, jockeys, and trainers change their equipment and strategies. Sometimes the changes are beneficial. Further, track records are a guide, e.g., in the Belmont, roughly 80% of the time the winner is neither the Kentucky Derby or the Preakness winner.

How do you pick winning investments? Please share.

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Investment Selections Improve with Adjustments Before Eliminations

Too many mutual fund and separate account managers are selected by bracket rankings as used in basketball, World Cup football (“soccer” as we call it in America) and tennis, unlike golf and horse racing. In the first three sports, the winner and other high ranking finishers are derived from their last bracket victory without the recognition that some losing competitors are materially better than some of the winners of weaker brackets. In other sports analysis, sophisticated watchers adjust the results for many variables such as the conditions of the competitors and the conditions of the competition itself. Intense followers of sports are not the only ones to adjust their thinking and actions before their rooting begins.

MUSICAL AND INVESTMENT ADJUSTMENTS

This weekend Ruth and I had the pleasure of listening to the Boston Symphony Orchestra (BSO) and the Boston Pops, both in concert and in rehearsal. Each of the overlapping groups was made up of very talented professional musicians probably at the heights of their musical careers. Nevertheless their equally talented conductors clearly modified how each piece of classical music was played. In watching and listening to the maestros one could detect adjustments they wanted the performers to make in well known pieces that have been played, in some cases, for hundreds of years. I am not a music critic, but I recognized that some of the adjustments made during the performances were similar to the adjustments that I believe should be made when examining the performance records of various equally talented investment managers.

Looking at the parallel adjustments between the two very different art forms can be instructive. In each case the conductor knows that while past performances can be illustrative of the desired future performance, today’s conditions (known and unknown) are different.

Pieces of music and individual stocks, bonds, or commodities were originated to stand on their own. In the real world they are going to be used in conjunction with others, e.g. a Beethoven program, overtures to great operas, love themes through the ages, the development of the American musical, etc. An individual security may be only one component of a concentrated portfolio with a singular focus, or a broadly based portfolio to participate in a general market movement, or an asset allocation portfolio, etc.

A great concert is not just a collection of individual pieces of music, it should be one with a point of view. Similarly, a successful investment portfolio is not just a collection of currently highly performing positions. Thus, I look beyond the aggregate performance of a fund to see how many securities contributed meaningfully to the overall performance. To my mind, a fund with one or two spectacular winners, (particularly if they are initial public offerings or from one segment of the market) is very different than a diversified portfolio producing similar results.

PERFORMANCE FACTORS

While the great maestros can get better results from each of their players on any given day, there will be a range of skills delivered, just as a portfolio manager needs to recognize the different level of research that he/she is utilizing. Some fund managers rely on a deep culture of professional research analysts within their shops, such as the American Funds (Capital Group is their manager), T. Rowe Price, and Janus. They will give an investor a steady result different than a brilliant solo performer like Fairholme. Good orchestra leaders vary their programs and interpretations to a lesser degree. Portfolio managers are selected by the turnover of their audience (shareholders) which are often a demonstration of time horizons. CGM Focus has attracted short term investors by its volatile and sporadically good performance but has a very good long term record. Other funds with solid long term records who are able to buy bargains in down markets because they raised cash in high markets attract long term investors; good examples of these are the various Mutual Shares funds, the Dodge & Cox equity fund, Longleaf, plus some of the Ariel and Marsico funds.

COMMUNITY OF INVESTORS

Many (if not most) of the members of this blog community are serious professional investors. You manage money for yourselves and for your clients. What distinctions do you apply when looking at fund records? What eliminations do you make from the leader lists? What filters are you using and will you share any with us?

COMMUNITY OF CONTRIBUTORS

Before leaving the BSO and the Boston Pops there is another important contributor to their beautiful music that I should acknowledge. Over many years the BSO has built a very large community of contributors. As a contributor and investment advisor to numerous non-profits, I am envious of the size and composition of their program book’s advertisements and endorsements. As with portfolio management organizations, producing good results over time is rewarded with capital that promotes successes in future generations.
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SHOULD WE APPRECIATE BONDS?

As a result of training, part of my pleasurable weekend routine is the reading of Barron’s. This week’s issue devotes a half-page to a summary of a forthcoming 17-page piece by the respected investment authority Robert D. Arnott. A longer review of the same piece is covered by John Mauldin’s weekly letter. Both articles focus on the “myth” of a 5% equity premium of stocks over bond returns, and include Arnott’s chart of bond and stock indexes. (This not the time or place to discuss the fact that there are flaws built into indexes which can lead to faulty decisions.) Arnott’s conclusions do not take into consideration either transaction costs nor the tax impacts of capital gains. These deficiencies are understandable because they are not major concerns of the large tax-deferred or tax-exempt institutions who are Arnott’s main customers. Nevertheless, the data is somewhat startling.

In the 68 years from 1803 to 1871, bond returns beat stocks. The period includes three land wars, either within our country or on its borders. Significantly, the period ended before the credit and liquidity collapse of 1873. That period has many more similarities to the present conditions than those of 1929-1933. In the 20 years between 1929 and 1949, including World War II, bonds again outperformed. Many believed that WWII was caused by the worldwide Great Depression. Almost all data is “end point determined,” i.e. if 2006 was used as an end point, a much different result would have occurred.

I come from a bias in favor of equity, and almost disregard high quality bonds in the real world as did Franz Pick, who called them “certificates of confiscation” due to their decline in purchasing power when principal is returned with less-valuable purchasing power than when it was lent. Despite my bias, I do recognize that bonds perform better than stocks in some periods. One can clearly identify with that occurrence in periods of declining equity prices, which probably happens in one in four years, often tied to the U.S. presidential election cycle. That explanation would not count for a little more than half of the period cited, 129 out of 206 years. The superiority of bonds also must include long periods of flat or trendless markets.

How should we apply this research? Arnott believes that equities are more attractive today than they have been due to their higher-than-normal yields. I would suggest one of the reasons for the higher yield is the uncertainty of many dividends. And, I may add, the long period of equity underperformance would make stocks attractive at some point.

The stock “bulls” focus on the recent stock purchases by Warren Buffet, Ken Heebner, and Jeremy Grantham. (Three disclosure points: First, I have owned Berkshire Hathaway for a number of years both personally and in a financial services hedge fund that, after fees, produced the same a less-than-stellar -32% in 2008. In addition, Ken Heebner’s CGM Focus is in a number of our managed accounts, as well as some pro bono accounts that I influence. Finally, I have known and respected Jeremy Grantham for many years.)

The appropriate term to be used is fixed income now, not bonds as we are dealing with loans, mortgages, derivatives and similar instruments. Three institutions which I serve on a pro bono basis are in the process of building up their fixed income investments. In each case, well-respected investment managers are leading the charge. They are seeking good credit managers to advise whether or not to go directly into the PPIP (the Public-Private Investment Program unveiled by the Treasury Department last Monday), or some other beneficiary of the process of supplying liquidity to an illiquid part of the market. All of these participants believe that they have at least one year to catch the built-in inflation that has been baked into the global economy by the various governments.

From my vantage point, I recognize the potential capital appreciation of fixed income. In the past, most of the institutional portfolios which I have managed or influenced have used bonds as a strategic reserve to reduce the impact of potential equity declines. Until very recently, I have favored the use of the highest possible quality money market vehicles. However, due to the protracted low interest rate environment, I have not counted on high-quality bonds to produce meaningful income.

I now am coming to the belief that we should devote some portion of our portfolio to the capital appreciation of fixed income opportunities when and if skilled managers can be found. That is now my search. Both suggestions and comments are most welcome.