09-Jul-2006

>Five Key Fund Investment Lessons

The Morningstar Investment Conference is one of the best events of the year for fund investors. But few individual investors actually go; the audience is mostly financial advisers and money management pros, experts who in many cases are worried more about the latest trend than about the basics that make for investment success.

An average investor who came here for the recent Morningstar event and listened carefully would have come away with five big lessons that seemed to come up in session after session:

1. Beware the attraction of short-term bets when looking for long-term outcomes
There have been countless studies of fund investor behavior showing that typical consumers don't do as well as the funds they buy. The discrepancy is caused mostly by losing confidence in a fund and jumping around, constantly trying to make headway with whatever is hot today.
Michael Mauboussin, chief investment strategist for Legg Mason, compared it to grocery checkout lines or changing lanes in the highway, always searching for what appears to be the fastest route to your destination.

"Very rarely does changing lanes get you there significantly faster," Mauboussin said during his keynote address, "but there are risks involved in making the change and you can wind up further behind -- or worse -- if you make the change at the wrong times."

2. When it comes to information, 'availability bias' is a problem
Morningstar is in the investment-research business and has made its name helping investors see through the skin of securities, first mutual funds and then stocks and exchange-traded funds. Where old-time investors had to rely a lot more on blind faith, today's investors have tools -- like Morningstar ratings, regular performance updates and much more -- that they depend on.

But several speakers noted that investors tend to have a problem with "availability bias," where they confuse access to information with relevance. Think of it like the Queen of Hearts in "Alice in Wonderland," where every bit discussed in court is decreed "very important!" although most of it is meaningless.

Investors frequently ascribe significance to short-term performance numbers, or watch the flow of money into various asset classes, thinking they say something important about long-term trends; frequently, this is how people wind up missing out on gains and buying into declines.

3. About half of all funds available today deserve to die
No one actually says this on the podiums at the Morningstar event, but they whisper it in the exhibit hall and in conference rooms.

The exhibit hall featured a number of companies whose best products could charitably be called mediocre, but realistically should be described as awful. Many firms created funds simply more for their ability to sell them rather than their capability for managing them well.
Thousands of laggards would be out of business if fund investing was a meritocracy. Since fund companies won't close these funds, it is up to investors to hold funds to a simple standard, namely that results are not disappointing over a long stretch of time.

4. Expect large-cap stocks to hit their stride in the next 12 months
You can't go to an investment conference without getting some prognostications for where the market is headed, and the consensus among experts at the Morningstar event was that the big names are due for a pick-up.

Large-cap stocks -- particularly for value-oriented investors -- are about as cheap as they have been in a long time, having lagged small-cap stocks for six to eight years (depending on which benchmarks you prefer). Stellar fund managers such as Bill Nygren of the Oakmark fund or Bill Miller of Legg Mason Value Trust have been migrating towards large-cap names.
For buy-and-hold investors -- as well as people who fled the bear market for the comfort of recognizable names -- a boost in the large-cap arena would be good news indeed.

5. There's a balance between running with the herd and being so contrarian you're wrong
Many of the top managers at the event discussed how they like to go against popular thinking, with the basic idea being that when everyone on the deck of the ship tilts to one side, the safest place may be the other side.

But the only difference between a contrarian and a fool is that the contrarian tends to be proven right (eventually), while the fool who kept trying to beat the herd failed to even keep up with it.
In plain speak, that means that when all of the experts start loving, say, large-cap stocks, that doesn't mean it's time to bail out of everything else. Diversification allows you to participate in the best of the market, no matter which way certain asset classes are running.

03-Jul-2006

>Moats and Risks

Finding great companies is as much an art as it is a science. If successful investing were as simple as plugging historical numbers into an equation, excess returns could theoretically be had by all--and therefore by no one.

The best approximation of a firm's intrinsic worth is the present value of its future forecast cash flows discounted at its cost of capital. This definition inherently contains plenty of "science," but the key word here, where the paths of different investors often diverge, is "forecast." It is here where variation of opinion and intuition regarding a firm's profitability, competitive advantages, and cash flow certainty create the opportunity to dig up treasures now that few others see until it's too late.

Bridging the Gap
There are several tools that we can use to interpret the fundamentals of a firm in order to bridge the gap between art and science, hopefully paving the way to a nice profit in the process.

Two of favorite bridges that help us arrive at a prediction of a company's intrinsic value and a "consider buying" price are moat and risk.

Briefly, an economic moat is a firm's ability to utilize its sustainable competitive advantages to outperform rivals and earn returns greater than its cost of capital.

The risk of a company, on the other hand, is the strength of the underlying business and the predictability and certainty of its future cash flows. Risk is determined by analyzing factors such as cyclicality, leverage, legal issues, and other outside events. In turn, risk ratings affect the size of the margin of safety that we build into our investment.

But not everyone's opinion, interpretation, or prediction of these metrics is the same. This is where we believe value can be found: by correctly selecting firms with economic moats that are trading at attractive discounts to our fair value estimate, given the margin of safety implied by risk rating.

Causation or Correlation?
So how exactly should moat and risk be interpreted in the investment decision-making process? Below is a breakdown of the 1,797 stocks we cover at Morningstar as of June 28, 2006:

The critical point is that, in general, stocks with moats tend to have lower risk ratings, and no-moat stocks tend to have higher risk ratings.

One can conclude from these figures that there is indeed a strong correlation between moat and risk. However, it's not a causal relationship. Not all stocks with moats carry low risk, and not all risky stocks lack moats.

The Great Sports Metaphor
Let's compare moat and risk in the context of something a bit less intricate: baseball. What makes a moat for a baseball team? Perhaps it is the club's ability to earn returns (score runs) greater than its costs (its opponents' runs). Let's go with that. If a team can do this--outscore its opponents--for an extended period, it will have an excellent record. A baseball "investor" would want to own a team with competitive advantages--such as strong hitting and pitching--that wins more games than it loses in the long run.

So what determines the riskiness of a team? Remember, we believe that the risk of a firm represents the certainty of its future cash flows, or our confidence in our fair value estimate and the price at which we would recommend investing. Baseball risk would therefore be the year-to-year predictability of a team's record. Contributing factors would be those such as the club's experience, performance consistency, player turnover, and injury-proneness.

Whether you're a fan or not, the New York Yankees are one of the most consistent baseball teams in history. They would most likely be awarded a low risk rating. But not only are the Yankees consistent, they are consistently successful. It is not hard to see how a set of low risk factors can coincide nicely with a winning record. After all, a steadily performing, experienced team of healthy veterans (a team with low risk) has little else to worry about except getting better; consequently, it may very often be able to best its opponents throughout the season.

Back to finance. Take companies like Microsoft MSFT, Coca-Cola KO, or Fastenal FAST--all firms that we believe have both wide moats and below-average risk. Like the Yankees, we think that the likelihood of these corporations outshining their respective competitors in the long run is good. We also believe that the transparency and certainty of their future cash flows is rather high--hence the low risk rating and small margin of safety.

While a wide moat and low level of risk do not cause one another, they are certainly related, or derived from the same kinds of "scientific" metrics.

Think of it this way: A firm's ability to outperform peers and earn more than it spends usually results in strong cash-flow generation.

In an "iron-sharpens-iron" sort of manner, strong cash flow can often build on itself, muting cyclicality, reducing the need for leverage, and making returns more predictable. Just like the low-risk baseball team, more-predictable returns mean that the company can better concentrate on moat-widening operations rather than risk-narrowing ones.

There Are Always Exceptions
Just because a firm has a moat or wins more games than it loses does not mean it is without sizable risk. Every so often, an inexperienced, "risky" baseball team with a more-uncertain future emerges as a league-power. This kind of team may be much more unpredictable than your typical moaty team, but its ability to defeat its opponents may nonetheless be undeniable. Might this team still be a good "investment"? Certainly, we would say, but only at a much larger discount to our fair value estimate!

A great corporate parallel here is Merck MRK. We believe that Merck has an economic moat; its successful portfolio of proprietary drugs has enabled it to outperform competitors and generate high returns on capital. If all goes well, we expect this to continue. However, our certainty in the level of its profits and cash flow is less than with a typical firm. Merck's shares may be subject to considerable volatility, as lawsuits and legal costs related to product recalls threaten to stifle its ability to keep cash flows consistent.

Finally, let's take a quick look at the opposite extreme: a below-average risk, no-moat stock. The leading bookseller in America, Barnes & Noble BKS, operates in a fairly stable industry with reasonably predictable cash flow. However, the bookselling trade is a rather stagnant business and tends not to provide returns on investment in excess of a firm's cost of capital. Barnes & Noble would therefore be akin to a baseball team that, while reliable, is unfortunately expected to reliably chalk up a losing record year after year (sadly, my beloved Chicago Cubs come to mind).

Clearing the Bases
The key takeaway from this discussion is that risk rating is considered separately from--but is by no means unrelated to--a firm's ability to sustain an economic moat.

Furthermore, while the moat rating affects discounted cash-flow modeling assumptions, the risk rating directly contributes to our margin of safety.

Microsoft and Merck earn similar wide-moat benefits in our valuation model, but we would prefer to buy Merck at a 36% discount to our fair value estimate, while we'd be comfortable buying Microsoft at just a 15% discount.

Therein lies the difference. Moat reflects our confidence in a firm's competitive position, while risk reflects our confidence in its future cash flows and the price at which we'd consider buying.