The Business of Investing vs. the Profession of Investing

September 3, 2005

Have you ever noticed that the smartest person at the party often has an opinion different from everyone else? How do you know when to go against the crowd? The key to having this clear insight is to understand the difference between the business of investing and the profession of investing. The difference is...

The business of investing is about selling investments and generating fees. You can see this at all levels of the industry. The financial planner or broker you meet is on the front lines working with investors. Most find that it is much easier to sell something that has done well recently. The easy and generally profitable thing for a planner or broker to do is pick something with a great short term track record and gush about it. Especially if they are new in the business, when it is hard to say you are wise and experienced, you can always point to great recent returns and say: "This fund is doing well."

What is wrong with that? Don’t we want investments that are "doing well"? As humans, we tend to see patterns and expect them to continue. The truth, however, is that "doing well" and "will do well" are completely unrelated. Many studies of various types always conclude, somewhat surprisingly, that you actually make more money buying investments that are not "doing well".

Why? Markets go through cycles. The disclaimer on every mutual fund is: "Past performance is no guarantee of future performance." We all know it is better to "Buy low and sell high." When you buy an investment that is "doing well" recently, usually you are actually "buying high". The average amateur investor is always searching for something that is "doing well" and dumping what is not. Studies consistently show that most investors follow their heart and buy what is doing well, which means they continually buy high and sell low - over and over again.

You would think that the mutual fund companies are much smarter than this, since most have been around many years and they specialize in investing. However, mutual fund companies are a business as well. Recently, most are talking almost only about investing in various defensive sectors - oil, resources, income trusts, resource-based countries like Canada, balanced funds and guaranteed investments - all of which have done well recently. With stock market returns lower the last few years, the easy answer is to sell any investment that pays out a regular income. Only a few years ago, most of these same fund companies were talking all about technology and other hot sector funds - and not about anything they are talking about now.

We often use the mutual fund companies as negative market indicators. They create new funds in sectors that are peaking and close funds in sectors about to make a comeback. Back in the late 90's, they were rushing to come out with the latest tech fund or hot sector fund. Now, they are rushing to come out with a new income trust or resource fund, or anything that pays regular income.

At the same time, the 2 best far east funds in Canada have both closed because they are too small to be profitable. While China’s economy has been hot, their stock market has not been. Why would a fund company close the top fund in Canada in a sector everyone is sure has excellent long term potential? Not enough sales recently, so the fund is too small and not profitable. Does that seem very short-sighted? Of course. Mutual fund companies often seem no smarter than the typical amateur investor buying whatever has been hot recently.

Of course, the fund managers, themselves, would be smarter - right? After all, they are investment professionals. The truth is that most mutual fund managers are salaried employees just trying to keep their job. They try to make sure the returns of their fund are not much different than the index, since they can lose their job if they perform much worse than the index. It is common in the investment industry to quote John Maynard Keynes: "It is better to fail conventionally than to succeed unconventionally." In Canada, fund managers often say: "You can’t be fired for owning the banks."

And let’s not even talk about the press. They are always focused on the latest hot trend.

Where does this leave us? With fund managers trying to approximate the index and the press, fund companies and planners/brokers all pushing whatever has done well recently ("buying high"), and the average investor following their heart, it is not surprising that most investors get low returns long term.

What is the alternative? The profession of investing is about earning the highest long term returns, taking into account the risk level. Again, you can see this at all levels in the industry. As in any field, there are exceptional fund managers that far out-perform their peers over time. They are usually students of the science of investing and insightful writers. They are not salaried, but own their own investment firms. They beat the market indexes by wide margins over time - and can tell you why. Their average returns are 15-22%/year compounded for 15-40 years!

These fund managers always have a disciplined strategy that they follow - whether it is in favour or not. They never get caught up in current fads and most are usually buying stocks that are not "doing well". Since I still love hockey, I call them "all-star fund managers".

Most fund companies are focused on trying to sell funds managed by their in-house, salaried fund managers. Some, such as C.I. Funds, try to find the best, independent fund managers. And some fund companies, such as Brandes Investments, are actually investment companies owned by an all-star fund manager.

There are also financial advisors, like myself, focused on finding these all-star fund managers. I find these all-stars for my clients and follow their strategies and ideas, even after they retire, for their wisdom. Depending on where you draw the line, there are probably 20 or 30 of them around the world, and about half of them have retired. The all-stars are not usually easy to identify - except after many years. A fund manager can be lucky for a few years or just have their investing style in favour. Even the best investors, like Warren Buffett, have periods of time when their style is out of favour. Buffett, the best investor of all time, had low returns in the late 90's, when everyone was making money in tech. However, once we identify the all-star, they can provide invaluable insight. Following the all-star fund managers can make you sound exceptionally wise.

The most interesting times - and the most fun at parties - are when the all-stars’ disciplined strategies are out of favour - when the all-stars are going against the crowd - as they are now.

For example, we have recently seen oil rise from $12/barrel to $71 in 7 years. A few years ago, there were a few books by experts on how we would eventually hit the "peak" in oil, meaning the maximum supply of oil we can get out this earth per day. With demand always growing, this point would signal oil prices skyrocketing. The experts debated whether we were 10 years or 40 years from the peak.

We have now had a series of oil supply crises - the Iraq war, Russia oil nationalizing, several hurricanes, terrorist attacks in Iraq and Saudi Arabia, a protest in Ecuador, strikes in Venezuela, Nigeria and Norway, etc. - and the price has skyrocketed. We read every day in the newspaper about the huge growing demand from China and India, and that the high oil prices are here to stay. This year, oil companies are almost the only part of the stock market that is rising, since high oil prices are bad news for most companies. Is this the peak arriving early or a temporary bubble? This is the biggest debate in the investment industry today.

What are the all-star fund managers doing about this stunning rise in oil? Interestingly - none of them are focused on buying oil companies today! (Although some bought oil a few years ago.) None of them are talking about focusing on oil-rich economies like Canada (except those that only invest in Canada). All of them are finding other investments that they think are much better than buying oil companies now. They are just talking about excellent companies or solid companies at great prices - the same old strategies that have vastly out-performed everyone for decades. They are among only a few voices not pushing the latest oil company or income trust.

Do you believe the news media, the brokers, planners and fund companies from the business of investing - or the all-star fund managers? Do the all-stars know more about oil than anyone else? No, but they know the difference between hype and quality investments. They understand that high prices will eventually create more supply and less demand, and that temporary supply disruptions end.

As a financial advisor, the easy thing for me to do now would be to tell all my clients that they should get into this hot trend and "look at the great 3-year return on this resources fund or income trust fund!" However, why try to keep timing the market and buying high when we can always end up right in the long run by following the all-stars?

We all now acknowledge that technology in the 90's was a bubble. At the time, however, there was all kinds of information about how technology was changing the world and the potential was limitless. Tech companies had exponential growth. Those from the business of investing claimed "this time it is different" and this growth is limitless. Now, it is hard to find anyone that believes technology will ever even come back. What were the all-star fund managers doing during the tech bubble? None were buying tech - except for those continuing to add to the tech companies they had owned for years. After the crash, some have been buying good tech companies "on sale".

Wisdom is that clear insight that comes from experience and knowledge. Now that we can find wisdom by following the all-stars, how can we use it? Of course, we can use it to invest effectively. We can use it to avoid getting caught up in hot trends and news stories.

But we can also use it in fun ways - by being the smartest person at the party. As I write this, oil just passed $71/barrel following hurricane Katrina. While everyone at a party is talking about how we are running out of oil, the latest income fund or oil stock they bought and made 30% on, the amazing growth of China and India, and the high price of gas, you can be the one wise person. Just tell them you think gas will be back below $1//litre within a month, the oil bubble is ending, $71/barrel is at or near the top and the price should plunge to $50/barrel or less, probably within a year. This should make the stock market take off and the high-quality companies owned by the all-star fund managers will out-perform again. Then who will want those boring income trusts?

Your friends will eventually wonder how you knew. If anyone asks you, just tell them you don’t get caught up in the business of investing. You follow the wisdom of the greatest minds of our time…