Picking Winners

The job of a professional investor is simply to pick winners, or is it? Professional investors focus on avoiding  losses (nominal or “real” )
and not appearing to act imprudently.

As regular readers of these posts already know, my two great learning schools were the race track and the US Marine Corps. The first taught me how to analyze and the second how to act. Allow me to share some of what I learned from going to "the track" in my quest to pick investment winners for clients and my family.

What is winning?

My betting objective for each day at the track and each season of visits was to finish with more money than when I started. As a wager of limited means I had to overcome my costs incurred including transportation, food, admission and the portion of winning tickets that went to the track and state/local taxes. For me these amounts could easily add up to a hurdle rate of 25%. Thus when it came to investing in the stock market or through mutual funds the costs seemed like a bargain particularly at long-term capital gains rates. With my objective of producing the first dollar of net profit after paying all incurred expenses dragging on my returns, certain basic strategies evolved:

          1.      Avoid losing by selecting only a limited number of races. (No multi bets or the equivalent of indexing).

          2.      Arbitrage the difference in potential payoffs between the winning payoff on a highly favorite horse versus half of the net pool for second place, if one of the first two horses is highly favorite.  At times such a bet may lead to a better return with some less risk than on betting on a favorite to win.

          3.      Look at current race conditions compared with the past record of the racers. Most often the odds on the horses that recently did well were less than those of horses whose immediate past results were poor. (For investors this is the difference between momentum investing or extrapolating vs. searching for new opportunities amidst almost always changing conditions.)

Applying winning strategies

Most fund selectors follow a disciplined approach to avoid losers;  they seek to avoid having any performers in the bottom performance quintile. If their remaining choices are averaged, they should have a performance record that is better than the average of the overall universe which is the equivalent of earning the first (small) dollar of profit.

The investment manager of a portfolio of funds, like me, constructs a mix of funds that in many, if not most markets should produce a satisfactory result. The way to do this is to diversify into a group of funds which will by direction and magnitude offset periodic losers with winners. The selection process should be guided by the assessing the chances of success over the chances of permanent loss of capital.

In contrast, the individual security analyst is most oriented toward the future, looking for the odds of meaningful changes that are not appropriately recognized in current prices.

The current picture

Market price correlations are widening; the price performance between the best performer and the worst are no longer parallel. This phenomenon could make the use of ETFs less useful. A number of actively managed portfolios are demonstrating that their selectivity is what produced better than average performance in the first quarter. In many cases the weighting of individual issues combined with good selectivity produced meaningful performance increments.

Dividend paying stocks have been leaders for over a year. But the focus is narrowing away from just yield production. JP Morgan is recommending common stocks of companies with high free cashflow production as companies that could increase their dividends among other uses of their cash generation. A number of mutual funds have either publicly espoused or just followed a strategy of selecting stocks of companies with rising dividends. The focus on dividends is part of what appears to be an almost insatiable drive for income to replace the former sources of reasonable interest on government bonds or bank savings accounts. This drive has caused an enormous flow of money into corporate bond funds. But this is beginning to show early signs of change. In 2010 the average trading turnover (the amount of trading vs. the amount of outstanding bonds) of investment grade bonds was 95% and now has dropped to 75%. This may indicate that the objective of trading to add to yield is declining a bit.

Searching

We have done a good job for our accounts, but at this point in the cycle I am worried that on a relative basis my accounts could use more future growth-oriented funds as well as highly selective fixed-income funds. If you have any suggestions in terms of techniques, or perhaps a securities analyst-trained person who should join us, please let me know.

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Similarities in Picking the SUPER BOWL Winner and Fund Selection

For many of us, this is the season of selecting which team will win the forthcoming Super Bowl. This year is a bit different for me because of this blog.

One reader recently asked me about fund selection, and the analyst in me forced me to list selection criteria topics that could apply to each selection task. I stopped when I had listed 25 items. To reduce mental strain on your reading, and writing efforts on me, I will only briefly discuss 14 of the items. For other analysts and exacting types who would like to read the entire list, please send me an email, aml@lipperadvising.com, and I will send you the list.

Before I begin, I should disclose that for the last 15 years I have worked with the NFL Players Association on their various retirement plans. I have been watching and thinking about the Super Bowl for many years before my professional responsibilities began.

SELECTION BRIEFS - For each selection point below, my Super Bowl comments are first, in bold.
The related fund selection comments are second in italics,
and my comments last, in plain type.

1. Compare the simple Won and Lost record compared with all other teams.

Compare Fund Performance Rank against all other funds.

Both sound bites are useful if the competition is in the past.


2. Analyze the success or failure in “Red Zones,” within 20 yards of the goal line.

Analyze the general price level of securities high vs. low.

Most of the time the game is played in mid-field or within normal price levels, but the big dollars are earned in extreme places both for the offense and the defense.


3. Examine the heroes, usually the quarterback and one or two backs or line backs.

Examine the Portfolio Managers or lead managers.

Unfortunately, little or no recognition is given to the offense or defensive lines (or analysts and traders). In many cases they make the guy up front look good while they do the hard work.


4. Understand that the Offensive Line protects the backs, creates the holes in the opposing lines and confuses the opposition.

Analysts, both within and outside a fund organization, see what others don’t or see it faster.


5. A Defensive Line breaks up the offense’s plays and protects their goal lines.

The contrarians look for weaknesses in momentum and uncover the big users of Cash.

In items 4 & 5, we see the importance of the supporting roles contributing to the success of the team and the fund.


6. In terms of compensation, both groups use financial incentives to motivate their teams. In professional football, the players have well-defined contracts.

In the investment world, most serve as “at will” employees, but often the bulk of their compensation is paid as a bonus.

Too often the bonus emphasizes current year performance and very little, if any, based on team-building and leadership.


7. A vital factor is the football team’s Front Office, who provides the financial and real estate resources to build the franchise.

In fund organizations, the business management often has similar responsibilities, including reporting to shareholders (both inside and outside), as well Holding Companies, particularly those of banks, insurance companies, and brokers.

Fund stakeholders usually have different (longer) satisfaction time thresholds.


8. Penalty-prone teams may try too hard, generating loss of yardage on the field, and fines off the field.

Similarly, a fund could wander or purposefully enter the “information gray zone.”

This straying action could negatively impact a fund’s performance.


9. Fan Support can be very encouraging at both open practices and game time, and may give some teams a big home field advantage.

Retail investors who buy with a broker’s assistance and 401(k) investors tend to be more patient than some institutional investors or pure no load investors who only focus on near-term performance or momentum.

The NFL team front office and a fund’s business management both understand the long term cost of losing their base.


10. The “Hail Mary Pass” is an extremely long pass thrown at the end of a game to attempt to reverse a losing score.

Similarly, a fund may have an out-sized position, often in a relatively, thinly traded stock during the last quarter of the year.

Both approaches have produced winners, but not as often as tried. Desperation does not produce comfort for investors nor fans.


11. A running game focuses on backs going through or around the defensive line, mostly resulting in short yardage that occasionally leads to big yardage and a score.

A fund, trading for small advantage in short periods often produces more highly taxed gains.

The tax orientation of the manager is often a good clue to who should own the fund.


12. The fact that any team in the league can win on any given day is particularly true in the last three games, especially after the teams that do not make the playoffs are eliminated.

A fund’s “season” is its performance, annual period. It is unlikely that a bottom performing fund can become a top performer late in the period, but it can happen. The winners are likely among the current performance leaders, or among those showing momentum. This is particularly true in a tightly defined peer group.

Do not despair for this year’s laggards. Often a particular period is being used to develop a winner over a longer time period, particularly when, or if, market conditions change.


13. What about a “Winners Curse?” To the best of my memory there has never been a winner of four consecutive Super Bowls.

The same can be said for funds. Except in the case of a long market, rarely do winners repeat three years in a row and even twice is difficult.

The winners become celebrities and at least become more expensive, if not more difficult to manage. The winners attract fair weather friends and fans who are more demanding than those who were steady company in the dark days.


14. Dynasties are extremely difficult to sustain. Start with the Winners Curse and the absolute fact that each year humans get older and more prone to the trials of the flesh.

Among these mortal groups are team scouts, who may miss insights or talent opportunities.

In the investment world there is no business-wide compensation cap, and only 100% of equity that conceivably could be redistributed and most of the time much, much less.


So after all this analysis what are my choices for ’09? You will understand that I can not make a public prediction as to the winner of the Super Bowl as all the participants are clients. However, going through the thought drill of the above items, I do not see that any single team has an overwhelming advantage. My guess is that the two finalists will be a surprise to most of us, and particularly one of them. The key question is whether the game will be close, which is a function of luck and the Zebras (the officials). So I root, as I do each game, for the Zebras. May they call a good game!

In terms of fund selection, I will go just a little further out on a limb for the non-paying crowd. First, I do not expect a repeat of this year’s winners. I expect the winners in 2009 to be more diverse than this year’s Dedicated Short Biased funds. The winners will be based on their individual security selection skills, which can be found in equities, fixed income and international securities. A top down approach will not be effective enough.

A number of winning portfolio managers will come back from long-forgotten victories, while other winners may be inexperienced investors who did not see the same risks that their colleagues feared in 2009.

Let the Games begin...