Mike Rivers' Blog Headline Animator

Friday, November 16, 2007

Concentrated money managers beat everyone else

Money managers who concentrate on a few well-researched ideas beat indexers and money managers who are closet indexers (those who mirror the index closely and try to tilt their portfolios in one direction or another).

Although I've long known this, it was nice to see this confirmed in a recent academic article.

The authors of the article created a unique measure for finding out how actively a money manager differs from an index.

Their research results indicated that money managers who differed significantly from an index in their holdings had a significantly higher chance of out-performing the index.

This may seem obvious to you, but many managers try to avoid risk by hugging an index. Such managers do this because they lack the skill to pick the best companies to invest in. Unfortunately, these managers still charge active management fees. Not surprisingly, their lack of conviction leads their investor to under-perform the index after fees.

This just goes to show what I always tell people: you should either index to match the market at minimum fees or find an investor who can beat the market after fees. Such managers are rare, but, if they can out-perform an index over the long term, they not only pay their fees, but lead their clients to reach significantly higher levels of wealth.

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.

Friday, November 09, 2007

Catching falling knives

One of the most difficult tasks in investing is to buy things as they go down. Psychologically, its no fun.

Hence, some investors refer to this as catching falling knives: you may do it right, but you may also get cut.

The payoff in investing can be huge. Buying companies that most people think will go bankrupt can be very profitable--if they don't go bankrupt. There's the rub, as Shakespeare put it.

How do you know the company in question won't go bankrupt? There are very smart people out there who know enough about certain businesses, bankruptcy, etc., who can pull this off. But it's not for the faint of heart any more than catching literal falling knives.

This question occured to me because a lot of very smart value investors are looking hard at mortgage and bond insurance companies (which I wrote about here and here).

Mortgage guarantee companies like Triad and Radian and bond insurers like Ambac and MBIA have been taken out to the woodshed recently, in terms of their stock prices. This seems justified considering they seem to insure a lot more than they could pay out.

Such investments were great as long as you assumed a housing recession or deep economic recession never hit. That doesn't seem like a very wise bet, now, nor did it beforehand.

The question is how will these investments do going forward? It seems hard to imagine the government will let the rating agencies downgrade their insurance ratings, for this would surely put them out of business and leave the financial markets in one heck of a mess (tons of investors have their money insured by these entities and would lead to a major dislocation).

But, do you want bet on that? That's the question. Will the government save these entities? Should their shareholders get off scott-free instead of bearing the risk they took? Will this encourage moral hazard (I can answer that last one--YES)?

Although I believe a ton of money could be made by investing in bond and mortgage insurers at these prices, I'm not expert enough to catch these falling knives. Do I know enough about the risks they've assumed and the capital they can use to support claims and the cozy relationship between rating agencies/the government/such insurers?

I don't. And not many do.

Perhaps that's why it might be best to leave catching falling knives to the experts.

As Warren Buffett put it, I don't try to find 7 foot fences to jump, I look for 1 foot fences to step over. Bond and mortgage insurers look like a 7 foot fence to me.

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.