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With the current state of the economy, there are many seemingly great deals available for investors who are willing to navigate the rough waters of the market. However, sometimes we can get caught up in our quest for the dollar and lose big. There are so many ways things can go very well — or horribly wrong — with the current market. So, be cautious as you evaluate those great deals and don’t jump the gun. In investing especially, patience is a virtue.

Don’t Forget Your Homework

Sometimes, you see the projected price and just want to buy before it shoots up and you feel like you’ve missed an opportunity. Remember, research and reading up on a company is a huge part of successful investing. Don’t just rely on what others are saying, but don’t negate it either. Make sure that your decision to buy is informed and that the risk has been properly assessed before handing your money over.

History Often Repeats Itself

This phrase is used over and over in many aspects of life, and investing is no different. Another aspect of doing your homework is to get a clear picture of the company in question’s performance over time. How did they fare the last time their price dropped? Is there a pattern developing? Will the company be around a year from now? Think about K-Mart a few years back — the price kept dropping until it was utterly worthless. Even at less than a dollar a share, the stock continued to falter until it could fall no more.

What’s Your Timeframe?

Are you in this for the long haul, or do you want to make a quick buck to jumpstart your entrepreneurial goals? This is a very important consideration, and one that cannot be understated. If you are looking for a fast turnaround in this market, you have your work cut out for you. Sometimes it’s better to look at things long term and make sure you are fully diversified so you don’t lose your shirt if things continue to drop.

Great Deals - Too Good to be True?

Sometimes you will see a deal you think you can’t pass up, only to see the price continue to plummet. Bide your time; even the biggest and brightest stars can fall. Especially if you are looking into a large mainstay on the market, consider their longevity and their ability to adapt to the demands of the current consumer. Will they make it five more years, or are their days numbered? Sometimes you’ve got to realize that no matter how good the deal is you may end up wondering what you were thinking later on down the road.

Making sure that you are doing the right thing is difficult in the investing world. Risk is involved and is something that you will ultimately have to weigh against your expected returns. Don’t be dazzled by the low prices or bells and whistles; use the data to make an informed decision. Knowing whether you made the right decision or not is only something time will be able to tell.

Side note: My recent post Share Buybacks - Pros and Cons was featured on the Carnival of Personal Finance #177. There are enough articles in this week’s carnival to last you a month. Enjoy!

This past week I read an article on GuruFocus by Andrew Mickey, CIO of Q1 Publishing, entitled “Don’t Buy In To Share Buybacks” and the ensuing discussion piqued my interest. In his article, Andrew presented his arguments about why share buybacks are bad news in the long run for shareholders.

I agree with his perspective somewhat. I don’t think it is possible to make an indiscriminate statement whether share buybacks are good or bad without examining the underlying motives behind each buyback decision.

As I’ve mentioned in my article Value Investing - Evaluating Management, it is important to always ask if management is acting on the best interests of the shareholders. Similarly, when evaluating whether a share repurchase is a good decision, we as investors need to decide if management made the right decision under the circumstances.

The Cons

As Andrew has pointed out, share buybacks may not be all good news. There are three motives we need to watch for when evaluating management’s decision of buying back shares with our money:

Mask Over-dilutive Stock Option Grants

One of the biggest crime management could legally commit is to grant themselves massive stock options at the cost of shareholders. Buffett has always said that if management wants a piece of the action they should pay. Nonetheless, stock options, when awarded reasonably based on certain performance metrics, can be an effective form of compensation to align management interests with shareholders.

Back in 1999, Microsoft issued about $60 billion worth of stock options to its employees.[1] At the time, Microsoft earned a net income of $7.8bln but issued options worth $9bln.[2] And none of these options were expensed, but that’s a story for another time. It wasn’t until 2003 when Microsoft announced it would stop issuing stock options, start granting restricted stock and start expensing stock awards.[3] One wonders if the $70bln stock buyback beginning in 2004 is merely to reduce the dilutive impact from the stock options it has issued throughout the years.

Earn Performance Bonuses

Carefully chosen metrics for performance-based compensation is essential to the success of a business. Management incented to increase share price could resort to gaming the numbers to prop up the stock price and ultimately earn their bonuses.

Buying back shares could achieve the same effect. By reducing the number of shares outstanding, management can almost immediately increase earnings per share, increase return on assets and reduce PE all at the same time. Best of all, management would have earned their bonuses at the cost of shareholders money!

Lack Capital Allocation Skills

Sometimes, buying back shares could mean management lacks the skills to find better use of excess capital. The question to ask here is can the business earn a better return investing elsewhere? A dollar retained should increase the value by at least a dollar. If not, the cash should be returned to the shareholders so they can divert the funds into other investments.

This is where understanding the business is important. Could the business earn a better return by acquiring a related business on sale? Should management invest in organic growth to sustain future revenues? Every case is different and need to be examined carefully.

The Pros

Needless to say, not all share buybacks are bad. Share buybacks can be beneficial in the following ways:

Catalyst to Narrow The Gap Between Price and Value

Substantial share buyback programs typically have an effect of helping the price converge on the intrinsic value sooner. This is, in fact, one of the weapons in the arsenal of activist investors to help realize the value of their investments.

When a share buyback is announced, management is usually sending a signal that the stock is undervalued and management is confident in the growth in future cash flows. Coupled with significant insider open market purchases, a share buyback could boost the share price in a meaningful manner. On the other hand, if after announcing the share buyback, management is quietly selling off their shares, you have to question the real motive behind the repurchase.

Tax Efficient Way to Return Money to Shareholders

Back in the days when capital gains tax is lower than dividend income tax, a share buyback is a more tax efficient way to return money to shareholders than paying a dividend. But since both capital gain and dividend income are taxed at the same rate now, the tax advantage has disappeared.

However, at the corporate level, there are still tax benefits to be had when buying back shares. A company that spends $100 million in cash to repurchase its shares will relieve itself of paying $9 million in taxes on the interest income it would have earned on the same amount had it kept the cash in a money market account earning 3% (assuming no growth in interest).[4] This tax saving in theory should translate into a $9 million increase in market price in a share buyback. In short, by returning the excess cash to shareholders, the business continues to generate the same cash flow but on less equity divided into lesser number of shares. Not a bad way to return money to shareholders and save on taxes.

Lower Cost of Capital

Buying back shares can be enhanced by utilizing cash from issuing debt. Remember, excess cash held at company is not free for company to use. After all, the cash belongs to the shareholders and the shareholders expect a decent return on the equity.

By issuing debt at an interest rate lower than cost of equity to buy back shares, the company has just increased leverage and lowered the cost of capital. This magnifies the return on invested capital to shareholders. What’s more, the interest expenses paid on the debt can be tax deducted. Again, the tax saving translates to an increase in share price.

Prevent Deworsification

When there are no other investments that could yield a better return than buying back shares, management should just return the money to shareholders. Spending the money on share repurchase also has the effect of preventing management from getting into silly acquisitions that would in the end cost huge losses to shareholders. Peter Lynch calls these deals deworsifications.

Dumb acquisitions could cost losses that run well into the future. Buffett calls buying Dexter Shoes with $433 million worth of Berkshire stock in 1993 the biggest mistake he has made. Although Dexter is no longer making shoes, Berkshire shareholders has lost $3.5 billion on the deal thus far and will continue to lose money as the shares increase in value.[5]

Conclusion

In summary, don’t be too quick to credit or discredit a buyback without first identifying the motive behind the decision. After all, if you were to draw a line here and consider all buybacks to be bad, you could be missing out on many, many great companies selling at a discount.

References

1. Rob Landley, Why Microsoft’s Stock Options Scare Me, The Motley Fool, February 17, 2000.
2. Bill Parish, Microsoft Financial Pyramid, Parish & Company, November 17, 1999.
3. Todd Bishop, Microsoft to End Stock Options For Employees, Seattle Post-Intelligencer, July 8, 2003.
4. Richard Dobbs & Werner Rehm, The Value of Share Buybacks, The McKinsey Quarterly - McKinsey & Co., September 20, 2005.
5. Jonathan Stempel, Buffett Calls Dexter Shoe His Worst Deal Ever, Thomson Reuters, February 29, 2008.
6. Justin Pettit, “Is a Share Buyback Right for Your Company?” Harvard Business Review, April 2001.

“Berkshire Hathaway is our largest holding because of Warren Buffett. Leucadia National is a large holding because of Ian Cumming and Joseph Steinberg. We think Eddie Lampert at Sears is a young member of that group.” When investing in a business, Bruce Berkowitz tends to pay more attention to the jockey than the horse because if a company has the assets and management to do well in tough times, the seeds for exceptional performance is already planted.[1] Even Mohnish Pabrai has expressed, in his recent 2008 shareholders meeting, that he is now focusing more on management.[2]

Evaluating management is not easy. The key here is to make sure management has integrity, intelligence and energy. “But the most important is integrity, because if they don’t have that, the other two qualities, intelligence and energy, are going to kill you.”, as Buffett pointed out. Remember, when you invest, you are entrusting your money to management. In The Intelligent Investor, Benjamin Graham tried to tell us that, in theory, the shareholders are the most powerful people at a company. We are capable of bending any management to our will. But he gave up after realizing that, in practice, many shareholders simply surrender their rights to management by voting according to management recommendations.

So unless you have the resources to secure a controlling interest at a company, you will have to rely on your ability to pick capable management you are willing to get in bed with. Here are four points to remember when evaluating management.

Take Management Communication with a Grain of Salt

Annual reports and company websites often have colorful photos of the executive team because someone must have figured out that putting a face next to a name makes the company more credible. That someone must have never read Leucadia annual reports. Try searching for photos of Ian Cumming and Joseph Steinberg and you’ll see what I mean.

When reading executive bios, always take it with a grain of salt. Guess who controls what goes into the bios? The executive backgrounds allow management to enhance their credibility by peppering names like Harvard and Yale. Not all information provided in the executive profiles is useless. For management who just took over the helm, the profiles hint at where management previously worked and how they fared. Also important here is how long has management been with the company. I tend to favor management who founded the company and stayed on.

Shareholder letters offer insights into how management communicates with investors. The tone of the letters are almost always positive and upbeat. The worst adjectives you could find in a letter are “challenging” and “difficult”. But they are commonly followed by a vote of confidence by management to calm the nerves of shareholders. This is understandable. But watch for management who draws attention to better looking but less important numbers to distract shareholders from focusing on the current problem.

Some investors advocate talking to management to get a better feel of their characters. I don’t think this is necessary. The danger here is management tend to have excellent oratory skills that might charm you into believing everything they say. In fact, some management thinks frequent communication with shareholders is all but a waste of time. Leucadia never holds quarterly conference calls.

The Juice Is In The Proxy Statement

Many investors tend to glean over proxy statements because annual and quarterly reports are already long enough. But what they don’t realize is the proxy statements contain crucial disclosures that could make or break an investment such as self-dealing. This is most evident in the Enron debacle. Had Enron investors read in the 1999 proxy about how CFO, Andrew Fastow, borrowed Enron funds to purchase energy related assets from Enron via his two partnerships, they would have balked.[3]

Another juicy tidbit offered in the proxy statement is management compensation including grants of stock options and restricted stock. It is important to pay attention to how management is compensated and how the pay compares to similar sized companies in the industry. Bonuses preferably in stock options or restricted stock should be awarded only if management hit a reasonable performance target.

Finally, the proxy statements also provide information about how much stock insiders own. Management should eat their own cooking. I expect management to have their substantial net worth invested in the company they run. Couple your analysis with the Form 4 filings to find out if management has been adding or reducing their stake. Recent significant open market purchases indicate a strong vote of confidence while significant selling by multiple executives and directors could be a sign of trouble.

Analyze Capital Allocation

To gauge the intelligence of management, observe how management act during tough times. Management that can keep the ship afloat when things go south will tend to do phenomenally well when the tide changes because weaker competitors would have faltered. Take AmeriCredit for example. Management has survived a credit crisis once back in 1998. Then CFO, Daniel Berce (currently CEO), made the right decision to reduce volume to conserve capital and came back roaring when the crisis subsided.[4]

Since the job of a CEO is to allocate capital wisely to maximize shareholder benefits, investors need to analyze deals made by management. The general rule of thumb as, Buffett always emphasized, is every dollar retained should produce a dollar or more in value. If not, the money must be returned to shareholders. Some CEOs, unfortunately, think they are paid to act. So in the interest of making themselves look busy they strive to make say five acquisitions a year. This is just plain stupid. If the deals are not going to produce a decent return for shareholders, the acquisitions are nothing but what Peter Lynch calls deworsification.

At some companies, the CEO is the key asset to the company. Study the deals the guy at the helm makes. We are all familiar with the dynamic duos Warren Buffet and Charlie Munger, and Ian Cumming and Joseph Steinberg. But there are some lesser known smart cookies such as Michael Ashner of Winthrop Realty who has consistently made some pretty amazing deals in real estate.

Apart from allocating capital, management is also responsible for maximizing efficiency. Days sales outstanding is a good measure of how quickly management can convert sales to cash. For financial companies, you would want to look at efficiency ratios, which is non-interest expense divided by net interest and fee income.

Don’t forget to look for signs of overspending in office buildings and unnecessary fringe benefits. Remember former Tyco CEO, Dennis Kozlowski’s $6,000 shower curtain and $2-million birthday party for his wife? Of course, these are hard to detect. But generally expenses should be in-line with same-size competitors.

Alignment of Interest with Shareholders

Responsible management always act in the interest of the shareholders. Ask yourself “Is the action in the best interest of the shareholders?” If not, sell your shares and stay away. The reason is simple: As a shareholder, the management team works for you. If you don’t like them, why let them manage your hard-earned money?

Good management would pay dividends when they couldn’t find a better use for the cash generated by the business. After all, as a shareholder, the cash belongs to you. If the stock is trading at a discount, they would repurchase shares to maximize shareholder returns. Of course, not all share buybacks are equal. But that’s a topic for another day. As mentioned earlier, look for management who eat their own cooking. They are more inclined to take the side of the shareholders.

References

1. Whitney Tilson and John Heins, Buffett: Still The Best Jockey, Forbes excerpt from Value Investor Insight, April 28, 2006.
2. Joe Ponzio, Notes from the Pabrai Funds 2008 Annual Meeting, FWallStreet, October 1, 2008.
3. Benjamin Graham with commentary by Jason Zweig, The Intelligent Investor Revised Edition, HarperBusiness, 2003. p. 500 - 501.
4. Andrew Osterland, Less Business Wanted? It Worked for AmeriCredit, CFO.com, October 22, 2001.

Side note: My recent post Valuing a Business - Seth Klarman’s 3 Methods was featured on the Festival of Stocks #110 and the Investing Carnival #17. Both carnivals are my favorites. Be sure to check them out.

“Price is what you pay. Value is what you get.” says Buffett. Valuing a business is, therefore, a fundamental skill that every value investor must master to be able to discern the intrinsic value of a business from publicly available information.

The truth is all of us can recognize a discount when we see one. When I shop for organic fuji apples, I know they are at a discount at $2.39/lb if they normally sell for $3.99/lb. Keeping an eye on the price tags is the key. But when it comes to recognizing a business selling on a discount, the share price does not always reflect the value of a business. This is because a business is made up of people. Hence, businesses evolve for better or for worse. When a business evolve into a more valuable business, the share price must at some point reflect this change.

The trouble is no one perceives the value of a business the same way. This is why even Ian Cumming and Joseph Steinberg couldn’t agree on the same intrinsic value for Leucadia. So when you throw the entire population of investors and speculators in the mix, you get a variable share price that changes by the second.

Business valuation is as much an art as a science. There is no one value that is the absolute right value for a company. Because of the imperfect knowledge of the future, we can only come up with a range of values for a company. Below are the three methods of business valuation that Seth Klarman postulates every value investor should have in his warchest.

Discounted Cash Flow / Net Present Value

In Theory of Investment Value, John Burr Williams was among the first to introduce the discounted cash flow (DCF) analysis. Seth Klarman categorizes this under the net present value (NPV) method. With a properly chosen discount rate and reasonably predictable future cash flows, the NPV method yields the closest to precise valuation of a profitable business.

DCF basically calculates the present value of all future cash flows by applying a discount rate. The discount rate is the interest that you would like to be compensated for incurring the opportunity cost of giving up alternative, less risky investments. The riskier the investment the higher the discount rate should be. Generally, the short term US Treasury securities are considered risk-free alternatives. In other words, if you are accepting a higher risk for an equity investment, you should expect to earn an interest higher than the current US Treasury yield. Don’t just apply a 10% discount rate on all analysis. A smaller, less liquid company probably deserves a higher discount rate, say 12% - 15%, than its blue chip counterpart.

Despite its proximity to accuracy, DCF has a flaw: it depends on predictable future cash flows which no one can reliably estimate given the massive number of variables. Unlike a bond, the earnings of a business are not fixed every year. A one percent difference in your growth assumption can have a huge impact on the NPV. Unfortunately, most investors are overly optimistic when it comes to estimating growth. The best defense here is to err on the side of caution and always pick the more conservative estimate.

Liquidation

The net present value analysis works great for determining the value of a profitable business with predictable future cash flows. But when it comes to valuing an unprofitable business, the NPV analysis falls apart. Since there is no future cash flow, you can’t calculate the NPV. [Note: This is an erroneous statement. Be sure to check out Tim Mayes' excellent explanation below for the reason.] Thus, most investors, unwilling to part with NPV, would simply pass on investing in unprofitable businesses. But this is precisely why investors who are willing to spend the time scouring the floors for cigar butts could find some wonderful bargains.

To value an unprofitable business, an investor needs to be extra conservative since many of these businesses are already troubled businesses headed for the dead pool. Typically, only tangible assets are considered. Intangibles such as brand names are assumed to be worthless. A good shortcut to evaluate the liquidation value of a business is to calculate the net-net working capital. Net-net working capital is calculated by subtracting current and long term liabilities from current assets. If the company trades below its net-net working capital and it is not depleting its net-net working capital nor does it have any off-balance sheet liabilities, the failing company could be a very successful investment.

However, there is a shortcoming with the net-net working capital analysis. Most of the time, in a liquidation, a company sells pieces of standalone operating entities too. These operating entities could very well be profitable going concerns despite its parent’s fallout. The net-net working capital analysis would have underestimated the worth of these subsidiaries. Often, in this situation, investors resort to a breakup analysis to evaluate the worth of the subsidiaries. Basically, you treat the subsidiaries just like you would any company when valuing a business; applying the proper analysis. Once you have the values of each of its subsidiaries you sum them up to arrive at the total value of the parent. This is also known as the sum-of-parts analysis.

Market Value

The market value analysis is the best and only sensible valuation method for closed-end funds. Closed-end funds are funds that are closed to new capital after launch and their shares can be traded at any time in open market. Unlike a mutual fund, a closed-end fund usually trades at a premium or a discount to its net asset value (NAV). The NAV of a closed-end fund is the sum of all its securities. Since the value of the securities are realized when sold to the market, only a market value analysis of the securities makes sense.

Some investors make the mistake of extending the market value analysis to valuing companies. The reasoning behind this is simple, but irrational; if a similar company in the same industry trades at 12 times pretax cash flow, this company should trade at the same multiple. This is what Seth Klarman calls “circular reasoning”. What if all the companies in the industry are overvalued?

A more appropriate relative valuation method for companies is the private market value analysis. The assumption here is that in a private transaction where sophisticated businessmen are involved, businesses are often bought at fair prices or at reasonable premiums. Often times, this is true. But when considering a leveraged buyout transaction for comparison, an investor has to be cautious about whether the buyer overpaid.

Conclusion

All three valuation methods are not without flaws. Therefore, it is sometimes necessary to use several methods simultaneously to arrive at a more comfortable estimate. It is important to pick the right tool for the right job lest you contract the man-with-a-hammer syndrome. As Munger would say, “To a man with a hammer, every problem looks like a nail.”

References

1. Seth A. Klarman, Margin of Safety, HarperBusiness, 1991, p. 121 - 135.

Side note: My recent post Value Investing - 6 Key Principals was featured on the Carnival of Personal Finance #173. As always, the carnival has some of the best articles I’ve read. Be sure to check it out.

There are many who count themselves value investors. In fact, they are really what Seth Klarman calls “value pretenders”. It is easy to be a value pretender. I was one. Following Pabrai blindly into buying Delta Financial cost me a lot of play money. Importantly, I learned the differences between a value investor and a value pretender.

A value pretender may not realize he is a pretender. He understands the difference between price and value. He understands that Mr. Market is here to serve him. He knows he should demand a margin of safety. He admires the value investing gurus so to the point of thinking they are always right. But he does not grasp the principals of value investing.

To become a true value investor, we need to first understand the principals of value investing. Below are six principals I think are crucial for an investor to truly understand value investing:

Risk, not profit

Often, when you read a stock analyst’s report, you find the target price prominently displayed on the report. This gives investors the information he needs at a glance. The danger here is once the investor sees the target price higher than the current trade price, he skips the rest of the report and completely forgets about the risk. This is akin to lending your hammer to your neighbor because he promised to return two hammers when he still hasn’t returned the hammer you lent him two years ago.

Unlike a value pretender, a value investor does not target a specific return. Risk is what a value investor targets first. Understanding risk helps you avoid losses. Only after you understand the risks of an investment can you then calculate the rewards. An investment that promise a 50% return in one year is a lousy investment if there’s a 50% chance of the business going under in three months. But an investment promising a 20% return in one year with an 80% chance of surviving the downturn can be a wonderful investment. The rules of investing laid down by Buffett are simple — Rule No. 1: Don’t lose money. Rule No. 2: Don’t forget rule no. 1.

Do your homework, but not too much

Understanding the businesses behind your investments is what separates value investing from other investing approaches. To get to know your companies well, you need to do your homework and study the fundamentals of the businesses. Doing due diligence is a pain in the butt. In Investing Mistakes - 5 Deadly Sins, I talked about the hundreds of pages of annual and quarterly reports to read, not to mention the 8-Ks and proxy statements.

But investing is one activity where you don’t get paid by the hour. Here the general 80/20 rule applies; the first 80% of the most useful information is gathered within the first 20% of the time spent.[1] Don’t strive to find the perfect information about a company. Knowing the secret recipe of Coca Cola does not guarantee a profitable investment. At some point when gathering information, you will hit the point of diminishing returns. Embrace the uncertainty and imperfect knowledge about a company that make the company a bargain. Besides, if it’s too much work, you can always pass.

Maintain discipline and patience

A value investor knows to take advantage of Mr. Market when he is being irrational. Timing the market is futile. No one can reliably predict the direction of the market let alone when the direction will change. To overcome the uncertainties, a value investor must insist on a huge discount to allow himself a sufficient margin of safety.

A riskier investment warrants a bigger margin of safety and a higher discount rate to arrive at a more conservative value. A discount rate is the rate used to calculate the current value of future cash flows generated by a business. If the stock doesn’t trade at or below your margin of safety, just don’t buy. Yes, you may miss the opportunity of a ten-bagger, but don’t forget you may as well have saved yourself from a company headed for bankruptcy. If you are patient, eventually, the price will drop to your buy price. Then, you would have made a killing. Remember, the profit is determined the moment you buy the stock. If you buy at a bargain price, you are almost certain of success.

Bottom up, not top down

Many investors continue to worry about the state of the current economy as they read about the soaring bankruptcies, the rising oil prices, the growing unemployment and the worsening housing slump. In this environment, value pretenders will predict and identify sectors that will outperform the market and begin searching for bargains there. The problem with this top down approach is you are buying based on a trend, almost to the point of speculating. You’ve decided a sector will outperform before you can perform value analysis.

A value investor understands that a company that is fundamentally strong and run by competent management will ultimately survive the downturn. Searching for a bargain begins from the bottom; you find a company and learn about the company first, not the industry. Nevertheless, there are some industries like the airline industry that are just not worth investing in. Still, if you focus on the fundamentals of a company, you don’t need to worry about the economy and market direction. In the long run, the price always converges on the value.

Change your mind

One of the most essential virtue a value investor needs is humility. Everyone makes mistakes. No one can make the right decisions all the time, not even Buffett when he sold Anheuser-Busch too early and left a big chunk of change on the table. Buffett willingly admitted he made this mistake and that is why people admire the man.

More importantly, once we learned that we have made a mistake, we must be willing to take action even if it results in a loss. The obvious case here is to sell when you realized you made a mistake in your analysis of a company. Too, when hunting for a bargain, a value investor must not get too attached to his first love. Unlike a marriage, infidelity isn’t a bad thing in investment. He may find a better bargain as he continues his search. And when he does and he has no cash available, he needs to trade his first love, even if it’s at a loss, for the better bargain. This is very, very tough to do. This is what baffles many people when gurus switch from one position to another, even though there is nothing wrong with the former position.

Absolute performance, not relative performance

Setting the right goal and focus could mean the difference between devastating losses and reasonable successes. The trouble with focusing on beating the index is we are too competitive. It is too easy to succumb to the temptation of trading just to beat the index every quarter. Ironically, this is the very reason many mutual funds underperform the index. The mutual fund managers are not entirely at fault here because if the fund underperforms the index in a quarter money starts flowing out to better performing mutual funds. The general public demand for short term performance will continue to ensure mutual fund underperformance.

On the contrary, a value investor focusing on absolute performance should do quite well in the long run. By setting aside the need to beat the index every quarter, you are forced to focus on minimizing risk while earning a decent return. If you do this well, you won’t be too far off from the index performance. Buffett uses an internal score card to gauge how he does in life. He posits, “Would you rather be the world’s greatest lover and let everyone think you are the world’s lousiest lover or be the world’s lousiest lover and let everyone think you are the world’s greatest lover?”

References

1. Seth A. Klarman, Margin of Safety, HarperBusiness, 1991, p. 102 - 115.

Side note: My recent post Index Funds - What You Don’t Know was featured on the Carnival of Personal Finance #171. This week’s Carnival of Personal Finance will be hosted by Girls Just Wanna Have Funds. Be sure to check it out on Monday.