Mutual fund over-diversification (the artist formerly known as di-worse-ification)

One of John Mauldin’s recent Outside the Box articles by James Montier (of Dresdner Kleinwort) highlights the fact that the average mutual fund holds around 160 stocks.

Now, this may not sound ludicrous to you, but let me walk you through why I think this is nuts.

First off, 160 is average. That means that some managers hold many more and some hold many less than 160, but let’s just work with 160 to illustrate my point.

There are around 250 workdays in a year (52 weeks minus 2 weeks for vacation gives 50 weeks, multiply that times 5 workdays per week).

Most companies report their earnings once a quarter and provide a conference call with that.

That means a mutual fund manager must monitor around 5 companies every 2 workdays (160/(250/4)x2).

Given an 12 hour work day and a 5 day workweek, that means each mutual fund manager can devote 4.8 hours per company each quarter.

Most conference calls last 1.5 hours, so that leaves only 3.3 hours to understand, model, value and evaluate each company.

Let me add that this doesn’t include time to visit companies, watch additional presentations that almost every company gives, look for new investment ideas, interact with clients, vote proxies, do administrative tasks, talk around the water cooler, etc. You get the idea.

Granted, such managers may have a herd of analysts chasing down details. But, the mutual fund manager is the one who has to make decisions, and how well can he understand a company and make decisions if he has so little time to follow and evaluate each company?

I know that when I look at a new investment, it usually takes me 3 hours just to read one 10k (annual report filed with the SEC). But then, I still need to read old 10k’s (at 3 hours a pop), plus 10q’s (quarterly reports filed with the SEC, 0.5 hour each), listen to conference calls and presentations (1.5 hours each), read current and old reports to shareholders (1.5 hours total), look up articles about the company (2 to 4 hours), read competitor’s reports (another 10 hours), etc.

In other words, just to look at a new investment idea, I have to spend around 20 to 30 hours just getting to understand the business. And then, I need to think about the business analytically, evaluate management, analyze competitive advantage, drill down into the business’s economics and business model, model the business into the future, analyze financial statements over time, etc. It takes a lot of time to thoroughly research a new investment idea.

To keep up with current investments, it usually takes about an hour to read the press release and think about and analyze the financial statements, 1.5 hours to listen to the conference call, 1.5 hours to update my model of the company, 1.5 hours to analyze the latest 10q or 10k, etc. It takes me about 6 hours per company just to stay up.

And then I still need to vote proxies and listen to annual meetings and analyst presentations!

It takes all my research time to keep up with 40 companies, have time to screen through a bunch of new ideas, and thoroughly research 10 to 20 new ideas a year.

So how can a mutual fund manager hold 160 stocks? By not doing a very thorough job of understanding the companies he owns. I think that’s an irresponsible way to invest. Perhaps that’s why 80% to 90% of mutual funds under-perform the market over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Black Swan

I have another excellent book to recommend: Nassim Taleb’s Black Swan (Taleb also wrote another favorite: Fooled by Randomness)

The book deals with a subject I’m always thinking about, the impact of improbable events. Taleb is an trader who seems to have made a career out of betting that improbable events may happen more frequently than most people predict, so he knows of what he speaks.

Taleb describes two countries, Mediocristan and Extremistan, which have very different characteristics. In Mediocristan, everything follows a bell shaped curve and is relatively easy to predict. He gives the example of the income of dentists, which tend to fall around an average and not vary too far from it. In Extremistan, however, things don’t follow a bell shaped curve and are almost impossible to predict. He gives the example of authors whose incomes are either extremely high (for very few) or extremely low (for the vast majority).

The reason he highlights this difference is a lot of people, especially academics in economics and finance, tend to assume that we live in Mediocristan even though we live in a world that resembles both Mediocristan and Extremistan. The height of people and the income of dentists are bell shaped, financial markets and the income of authors are not. The problem is that highly improbable events can easily overwhelm the highly probable events that most people focus on.

His point is important to acknowledge, because if you are measuring the height of people, bell shaped curves are great. But, if you are operating in financial markets, using bell shaped curves can be very dangerous (just ask the Nobel prize winners who worked with Long Term Capital Management).

I’m finding the book a pleasure to read because the subject matter is fascinating and relevant, and because I really enjoy his style of writing, which is laced with stories, examples and no punches pulled. Sometimes, he seems to be a bit arrogant in his way of describing things, but I’m usually more amused than offended by this.

I highly recommend the book to anyone operating in Extremistan for a living.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Is the economy permanently less volatile?

I recently read a fascinating research paper by Lewis Sanders at Alliance Bernstein.

In it, he argues that the US and world economies are more stable than they were in the past, and that this may justify higher equity valuations going forward than we saw in the past.

The paper is well researched and raises some great points. GDP growth, inflation and corporate profit growth have been remarkably more stable over the last 11 years than over the previous 39.

This has been caused by a host of factors, including: less volatility in defense spending, less inventory volatility due to better inventory management, improved trade due to trade liberalization, more flexibility in the financial services industry due to deregulation, lower default rates due to better lending, and more efficient company financing due to private equity firms.

What could shatter this lower volatility and lead to falling financial asset prices? The usual: increased regulation, trade barriers, and geopolitical risks. These would all lead to higher inflation, lower efficiency, less flexibility and more volatile growth.

In other words, the risks are almost all political, and therefore very difficult to forecast. I think the political pendulum swings one direction and then the next, so I’m worried that all the good news over the last 11 years may not continue over the next 10.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What to expect for long term equity returns

John Mauldin’s latest Outside the Box newsletter contains an outstanding article by Dr. Prieur du Plessis.

In it, Dr. Plessis shows clearly how current market price to earnings ratios and dividend yields provide a good idea of future 10 year returns. Quite simply, the higher the current price to earnings ratio, the lower the market return going forward, and the lower the dividend yield, the lower the market return going forward.

As Jeremy Grantham at GMO has stressed repeatedly, “the best case for caution and bearishness is value, which is a weak predictor of one-year returns, but a dynamic predictor of longer-term returns.”

In other words, valuation in the form of price to earnings ratios and dividend yields are terrible at predicting short term returns, but excellent at forecasting long term returns.

What is the current S&P 500 price to earnings ratio of 18.4 and dividend yield of 1.8% indicating? Returns of around 4-5% over the next 10 years.

If your retirement plan relies on higher returns while being broadly diversified or invested in the market, you may want to reconsider your investment choices.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Interest rates

For those of you not paying attention, the bond market has had an amazing month and a half!

If you are thinking to yourself, “What does the bond market have to do with anything, I buy stocks,” hold on to your hat.

Bonds are frequently used as the discount rate or the base rate from which discount rates on stocks are computed. This is most prevalently seen in the Fed Model, but is also the way almost every finance textbook used in business school starts.

If bonds drop in price, and their yields go up (as has happened lately), then stock prices should go down (all things being equal, and they never are). By how much? I’ll get to that below.

Back on May 2nd, the 10 year yield on US Treasury bonds was 4.64% and the 3 month yield on US Treasury bills was 4.87% (according to Value Line’s May 11 Selection and Opinion). Today, according to PIMCO’s website, the 10 year is yielding 5.30% and the 3 month is yielding 4.72%.

This is a massive change! The 10 year’s yield jumped 0.66% and the 3 month’s yield dove 0.15%. Because the bond market has such a huge impact on all discount rates in the market, this is a huge change!

For those of you thinking the stock market’s recent sell off has taken account of such a discount rate change, think again. The DJIA was at $13,211.88 on May 2nd and closed at $13,295.01 today, a 0.63% increase. All things being equal (assuming estimates on company earnings haven’t changed), the DJIA should be at $11,566.60–down 12.45%! Instead, it’s at $13,295.01, implying that earnings estimates for the DJIA have increased by 14.95% in the past month? I doubt that.

I’m NOT suggesting the Fed Model is correct or that stock prices should move precisely with bond yields, but I am suggesting that the stock market, and perhaps other markets, have not taken full account of recent bond price and yield movements.

Also, how do you think bond price moves will impact mortgage and housing markets? A 30 year mortgage on a $300,000 house should go up around 7% per month (or $130) based on this bond price change. Does it seem like that’s been figured into market prices for home builders and mortgage companies? It doesn’t seem like it to me.

As usual, I’m making no assumptions about what will happen in the market and when, but I do find recent bond market moves disturbing.

Perhaps bond prices and yields will go back to where they were, vindicating recent stock market moves. Perhaps fundamentals are improving just as quickly as bond prices are dropping and this justifies no move in prices.

I can’t predict what will happen much better than the next guy, but I am scratching my head and wondering what other people in the market are thinking.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Charlie Munger’s latest commencement address

For those of you who don’t know, Charlie Munger is Vice Chairman of Berkshire Hathaway and a hero of mine. Together, Munger and Warren Buffett run what I consider to be the best company in the world.

Munger recently gave a commencement address at USC Law School and someone present (Joe Koster) was kind enough to scribble notes of what was said. The speech is classic Munger: all over the place, thought provoking, no punches pulled.

Munger’s first comment was that the safest way to get what you want is to deliver to the world what you would buy if you were on the other end.

Next, he emphasizes how important it is to always be learning. Never accept where you are, be a learning machine.

He says a multi-disciplinary approach is a great aid to success. Venture outside your field, understand the most important ideas in as many fields as you can grasp.

He also mentions how useful it is to invert problems you are trying to solve. Instead of wondering what you need to do to succeed, consider what will certainly lead to failure–sloth and unreliability.

He suggests that you avoid extremely intense ideology. He warns that such an approach can lead to closed mindedness where new information isn’t honestly considered.

Don’t spend more than you make, he says. His example is Mozart, who was brilliant but miserable because he spent more than he made.

He says to avoid perverse incentives and associates. Both will lead you to do things you’ll later regret.

He suggest that you maintain objectivity by looking for disconfirming evidence like Darwin did. Most people only seek out confirming evidence, which can lead to confirmation bias.

With regards to people, he says you should pick the right people to be in important positions. Who are the right people? The learning machines with the aptitude and desire to never stop learning.

To be any good at something, you have to have an intense interest in it. This may seem obvious, but how many people chose to be doctors or lawyers because of the money instead of their interests?

Munger has a little fun with words when he says that assiduity is another key to success. Sit down on your ass until you do it. In other words, go to work until you get a thing done. Don’t make excuses, don’t whine, just do it.

Munger says not to suffer from self-pity. Things go wrong in life, and how you react to those things, whether fair or unfair, determines your success and happiness.

Munger suggests that he has done quite well in life anticipating trouble. It didn’t make him unhappy, and it made him ready to perform if trouble came.

His final idea is that a civilization built on trust (the kind you receive by earning it, not the kind you expect because you want it). Be the type of person who deserves trust, and you will benefit immensely.

Smart words from a very successful man. Thank you Mr. Munger, and Joe Koster.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Private equity buyout bingo

Will the private equity market continue to run as red hot as it has been?

William Hester, CFA of Hussman funds presents a fascinating analysis where he shows that the risk-to-reward ratio is thinning for private equity buyouts.

As Herb Stein (Ben Stein’s father) is famous for saying, “If something cannot go on forever, it will stop.” I have no idea when the buyout binge by private equity will peter out, but I can guess that interest rates going up will have something to do with it, and that it won’t be a very fun time to be invested in riskier stocks and bonds.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.