Most investors don’t know what they pay for funds
Being more selective can improve returnsJanuary 31st, 2019
If you were asked to make a purchase for a friend, one of the first questions they would undoubtedly pose upon delivery is, “How much did you pay for it?” This is a reasonable question given that most consumers want to ensure they’re getting the best price.
Receipt in hand, you confidently relay the price, and possibly even quote a few other, higher prices you found for the same item. Your friend is pleased, and the transaction is deemed a success.
This is a simple, and likely familiar, event that might occur in the U.S. and probably most cultures in the world. Why is it leading a piece on investing? It leads to this question: How much did you pay for the mutual fund or exchange traded fund in your investment account? My guess is that most people have no idea.
Considering that investment and retirement accounts comprise a major asset for most, it’s strange that investors often don’t know how much they’re paying and what exactly they’re getting for it.
The popular practice of fund investing is enabled largely by index funds that provide low-cost access to a broad range of securities. The trade-off for this low cost is indiscriminate buying and selling, with little ability to know exactly how much one paid for it. This is because these funds often hold 500 or more securities; determining the value an investor receives would involve examining each underlying security.
For example, some of the most popular index funds track the Standard & Poor’s 500, which are the 500 largest publicly traded companies in the U.S.
One of the constituents of the S&P 500 is Ball Corp., which makes containers for consumer products. Ball recently was valued at about $21 billion, which includes equity and debt, less cash. In 2017, the company generated about $900 million in cash flow. Therefore, it would take over 23 years for investors to earn their money back. If you were presented this company as a business opportunity, would you take it? I would pass.
That last point is one that a lot of investors seem to have abandoned. At its core, investments are made in individual businesses. This is highlighted in The Intelligent Investor, written by Benjamin Graham, who was a mentor to Warren Buffett, who said this book is “by far the best book on investing ever written.” If one isn’t willing to buy all of Ball Corp., one shouldn’t be willing to purchase a share of its common stock.
Thinking of investing as buying the whole business has wide-ranging implications, but we will focus on the importance of identifying and investing in good businesses. For these purposes, a good business has the following characteristics:
•A “sticky” customer base. In other words, if the company were to go away, would it be missed? Think of Google or Starbucks as examples.
•The ability to grow. Think of Facebook.
•A good management team, such as Buffett’s company, Berkshire Hathaway.
Leaving valuation aside for now, imagine that you owned all of Google, Starbucks, Facebook, and Berkshire Hathaway. That portfolio of technology, consumer, finance, and industrial companies is pretty well rounded when thought of as one’s personal portfolio of companies. Similarly, entrepreneurs and many other business owners often only have one or two portfolio companies as they own local McDonald’s franchises, car dealerships, office buildings, or hotels.
Having identified a good business, one can then take the more manageable step of arriving at a reasonable valuation of it. Obviously, valuing a company takes some work, but valuing four companies is much easier than trying to value and monitor 500 companies. If one’s view of value is well below the current market price, the investor can be patient and wait for the opportunity to buy.
This might take months or even years, but it allows the investor to take a much kinder view of market volatility. Even if a current portfolio company trades down in price, investors can use the opportunity to buy more because they know the company and are comfortable with its long-term prospects. This framework also allows investors to better target a required return, as they will wait for opportunities that allow them to achieve it.
The added benefit of only focusing on good businesses is that stock market projections and other noise are no longer relevant. Warren Buffett said that he invests in businesses with which he’d be comfortable if the stock market were to shut down for five or 10 years. Thinking of the hypothetical portfolio above, consumers likely will continue to use Gmail and YouTube, keep up with friends and family on Facebook and Instagram, seek their morning coffee, and buy insurance.
The potential advantage of private business owners is that they aren’t constantly bombarded by price quotations for their business, unlike public companies. The swings in prices, and therefore valuations, can be drastic, even for large established companies. For example, in 2018 Facebook traded at a valuation of as much as $590 billion, and as little as $350 billion, for a $240 billion change within a year. Therefore, investors must be patient, have a long-term view of their good businesses, and take advantage of the opportunities the market gives them.
Think of the local entrepreneur who bought the McDonald’s franchise prepared to hold it for many years. Why should investors with a long-term time horizon behave differently?
Lack of patience or a calm temperament, and not capitalizing on advantageous prices the market occasionally provides is discussed in The Intelligent Investor: “Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage.”
Proponents of investing in indexes such as the S&P 500 may point to some studies showing that their passive investing has outperformed a more active investing style. A rebuttal to this reminds them that most of the active funds included in the studies still hold 50 or 100 underlying securities. This is a lot of businesses to know and monitor, and much more than an entrepreneur or businessman would hold in his portfolio of companies. The businessman may cap his holdings at 20 companies, for example.
To further illustrate the point in Spokane, imagine owning The Davenport Hotel, the Bank of America office building, a Zip’s Drive-Inn franchise, Larry H. Miller Downtown Toyota, and etailz Inc. That’s a nice portfolio of five businesses, and plenty to keep track of. It is also reasonable to assume that you know the cost and expected return for each business.
Also, index investors might say that for every Ball Corp. in the index there are better investments, perhaps Google or Facebook. A response to this would be: That’s great, just buy Google and Facebook.
Of course, some additional work is required, and temperament is critical to this approach, but at a minimum, investors should think about what they’re buying and ensure that they’re achieving the best use of their dollars.
Christopher G. Malde, a chartered financial analyst, is the managing member of Spokane-based Malde Capital Management LLC, He can be reached at 509.789.0899.