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Too Active, Too Passive: Too Little Understanding

02/05/2013

The wealth management and institutional consulting communities have allowed indexing to be called “passive” investing and stock-picking disciplines to be called “active” management. This implies a mindless approach to indexing and a great deal of busyness to stock picking. A number of recent articles and commentaries have been written which question the viability of stock-picking disciplines in an era of numerous indexing choices and ETF vehicles. We at Smead Capital Management believe these labels are at the heart of a great deal of confusion about what works and what doesn’t work in both equity mutual funds and separately managed accounts.

The latest article we’ve read came on January 22nd, 2013 from Marketwatch.com. George Sisti, a guest writer on retirement planning, argued adamantly against “active” management in a piece called “Forget hot funds and market-beating managers”. His thesis: since nobody can predict the future or where the market is going each year, nobody can beat the stock market over long stretches of time.

Why not? Something called an efficient market — think of it as money manager gravity — which keeps even the smartest managers from outperforming the market over the long haul. In an efficient market, the current price of a stock is the consensus opinion of all those smarty types’ collective judgment. If their consensus opinion is that XYZ stock is undervalued, they will rush to buy it and its price will rise. Conversely, if they believe that XYZ is overvalued, they will sell it and its price will decline.

We believe it is correct to be skeptical of a majority of equity mutual funds, but believe thinkers are wrong about long-duration outperformance. We believe there are actually a number of very meritorious stock-picking disciplines which do add value for investors and there are a number of factors which argue in favor of effective “active” management.

Factor One —Valuation Matters Dearly

Eugene Fama and the others who came up with the efficient market theory have written extensively about mechanical valuation-oriented stock-picking disciplines. For example, Fama and French concluded that the lowest price-to-book ratio (P/B) companies outperform the market and the other categories. Even efficient market theorists have identified ways to beat the stock indexes. Here at Smead Capital, we found that Fama-French like academic studies by Bauman-Conover-Miller, David Dreman and Francis Nicholson all came to the same conclusion—VALUATION MATTERS DEARLY! Take any valuation metric like price-to-earnings, price-to–dividend, price-to-book, or price-to-sales and the lowest 20-25% of the companies outperform the index over both one and multiple-year holding periods. Additionally, it works with annual rebalancing and in Nicholson’s study as a static portfolio. In fact, the benefit of buying cheaply and holding statically grows more and more each year in his study.

Factor Two —Index Strengths and Weaknesses

Most discussions don’t delve into what indexes do. What the “passive” indexes do well or what they do poorly in comparison to actively-managed equity funds is never dissected. In a piece we wrote in March of 2010 called “Long Duration Common Stock Investing”, we explained what we believe the indexes do well and what they do poorly. Index expenses are low, turnover is low, trading costs are minimal, winners are held indefinitely, and market-cap weighting causes winning stocks to be magnified.

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