Investors should dare to be different

By DAVID MOON, Moon Capital Management
June 13, 2004

Despite the anemic returns in the stock market this year, investors continue to pour money into their 401(k)s, almost all of it into mutual funds. Some investors use this as rationale that stock prices must continue to increase, since more money equates to more demand. There are other consequences of this phenomenon, most of which are much more likely and influential.

Mutual fund companies don't improve their profitability by producing better investment returns. The most immediate impact to the bottom line of any money management company results from an increase in new assets to manage. New assets can come from two places: market appreciation and new deposits. New deposits are usually a much more predictable source of increased revenue.

Since managers have a greater incentive to attract assets rather than improve returns, they become more concerned with mimicking the returns of an index (usually the S&P 500.) Relative performance is more important than absolute performance, because three or six months of underperforming the index will result in lost assets ' and lost revenue.

Too many mutual funds companies are now marketing organizations, not investment companies.

More managers migrate toward the same stocks that comprise the S&P 500, concentrating greater assets into these securities. They have to, otherwise their returns might differ from everyone else's. A premium is placed on short-term performance, creating an exaggerated move of money to momentum driven portfolios.

While this is happening, the quality of the research produced by Wall Street firms is also declining. Investment banking used to provide the primary (and in some cases, the only) source of revenue for research departments. With the admitted scandals in these research departments, a separation is now supposed to exist between research and investment banking. Analysts who used to produce hundreds of millions of dollars in investment banking fees are now cost centers. Coverage is declining, and the research that is being done is performed by people who expect less compensation ' these are less experienced, junior analysts.

Another factor diminishing the value of Wall Street research is SEC Regulation FD. Back in the good ol' days, public companies would basically do the work of the Wall Street analysts. CFOs and investor relations executives would 'whisper' signals about upcoming earnings and changes in their business. Reg FD eliminates that, forcing analysts to do something new: analyze.

The result of these changes is that more opportunities are available for investors who are willing to be different. The ability to actually analyze data and understand companies is now more valuable than in any time in the last fifty years. The key is that investors must be willing to accept returns that are non-correlated with the short-term movements in the overall market. The unknowing sheep of Wall Street follow in the same path, afraid to be different. As legendary investor John Templeton said, 'if you want the same returns as everyone else, buy the same securities as everyone else.' That's a guarantee of, at best, mediocrity.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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