Value
managers may protect against funny accounting
Recent
stock market history is peppered with corporate scandals and creative
accounting that eventually bankrupted the companies involved and hurt many
investors along the way. Names like Bre-X, Cartaway Resources, YBM Magnex,
Laidlaw are a few names that reflect some of the same issues facing Enron
today. Many criticize professional money managers for missing the warning
signs. Is it realistic to expect managers to catch every Enron? If so, what
type of manager is most likely to steer clear of such firms?
In
baseball, offensive players that are successful four times out of ten (a .400
batting average) are rarities that are usually hailed as hall-of-famers. A .300
batting average is considered very good, but that only means a batter gets a
hit 3 times for every 10 attempts. Extending the baseball comparison: To be successful, money managers tend to
require a “batting average” of about .700 or so. Money managers are human,
which means they will make mistakes from time to time. Also, don’t be fooled
into thinking an unemotional model, such as one driven by a computer algorithm,
is the answer.
Investors
should expect even the best money managers to miss something from time to time,
but as long as they bat .700 or more, they should be successful over time.
The story
of Bre-X has been well documented so I don’t need to rehash it here. In fact,
the dramatic scandal was told in many books. In summary, Bre-X was a gold
exploration company that supposedly found significant amounts of gold in
properties it was mining. As a result, many analysts touted the stock as a
strong buy. The stock rose so high that it qualified for inclusion in the TSE
300, which caused index funds and all portfolios tracking the index to purchase
the stock. (The main TSE 300 qualifiers were how many shares of stock traded
each day and the value of all shares traded.) It was later discovered that
little, if any gold was actually found in these properties, causing the stock’s
eventual demise. Sound familiar?
While there
were many funds caught with shares of the controversial company, some never
even considered it as an investment. As of March 25, 1997 (when the scandal was
revealed) funds with the greatest Bre-X concentration included precious metals
funds from TD, CIBC, Maxxum, and Bank of Montreal, in addition to small cap
momentum funds by AGF (then 20/20 Funds).
Interestingly,
some value-oriented managers never touched the stock. Gold bug Jonathan
Goodman, who ran the Dynamic Precious Metals fund at that time, never touched
Bre-X. His value-oriented philosophy and preference for management with a
proven track record of industry performance kept him miles away from this stock
at all times.
It’s no
secret that I have a bias in favour of value-oriented managers. The reason is
that the mindset of a value manager tends to jive with my way of thinking. When
it comes to investments, I’m a skeptic who is often only satisfied with
something when I can’t find anything wrong with it. A similar skepticism guides
most value-oriented managers. For this reason, they tend to dig a little deeper
for things that could impair a stock’s value.
That’s not
to say that growth managers don’t do their homework – quite the contrary. It’s
just that more growth-oriented managers tend to have brighter outlooks than
their stingier counterparts. Value managers’ more skeptic point of view means
that they often have a different analytical starting point that may enable them
steer clear of such scandals.
Revisiting
the baseball analogy: Power hitters
tend to hit more home runs and drive in more runs, with more strikeouts. Value
managers tend to be more consistent – getting more hits with fewer home runs
but also fewer strikeouts.
My opinion
is just that – an opinion. It’s not based on any research, but rather on my
understanding of the general processes followed by different types of money
managers. Nobody’s perfect, but a fuller understanding of a manager’s approach
will give you greater confidence in your investing decisions – whichever way
you go.
Dan Hallett, B.Comm., CFP, CFA is Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, and Manitoba.