The Capitalist Investment Method For Helping
Our Clients Select Mutual Funds

The Usual

How do most investors select their mutual funds? Do they --

1) Carefully analyze the fund’s historical risk/reward characteristics and select a fund that matches their own risk tolerance?

2) Familiarize themselves with the portfolio manager’s investment philosophy, and invest with those managers whose temperament is most compatible with their own?

3) Diversify their holdings across a number of funds with different styles in order to reduce the volatility of their portfolio?

4) Chase returns by letting fear and greed lead them to funds with the best past performance?

Unfortunately, study after study has shown that most investors use method number 4. For example, “In 1999 US stock funds with the growth style averaged a 55% gain compared to 21% for the S&P 500. The following year they took in more than $92 billion, while more plodding value funds and bond funds slipped into net redemptions according to Boston fund consultant Financial Research Corp.”(1) What happened after growth funds tanked in 2000? Value and bond funds took in more than $160 billion combined in 2001 and the first quarter of 2002, while growth funds' inflows were about flat.(2) According to Lipper senior research analyst Don Cassidy, "People have a tendency to move toward comfort at all times. But moving toward psychological or emotionally comfortable decisions will probably hurt you over the long term. You usually end up buying high and selling low."(3)

This is not a new phenomenon. A study by Dalbar, a Boston fund consulting firm, found that between 1987 and 2006, the average mutual fund returned 11.3% annually, while the average fund investor only gained 4.3%.(4) What accounts for this chasm between fund and investor performance? Most fund investors, rather than sticking with a fund manager and an approach in which they had faith, and understanding that even the best funds are going to underperform at times, sold last year’s losers to buy last year’s winners, thereby guaranteeing that they would on balance buy high and sell low.

The Capitalist Investment Method

At Capitalist Investment Services, we help our clients steer clear of this pitfall through a three step process:

1) Risk Review -- we interview you to establish your personal risk/reward tolerance by having you answer a number of “Risk Profile” questions such as:

“If a mutual fund you had purchased lost 10% of its value in the first year, how would you feel and what action would you want to take?”

“Assuming your portfolio has one sub-par year in the next five, what is the worst return for that year that you could tolerate?”

“What average annual rate of return do you need to achieve in order to meet your objectives?”

What we give you in response to these and many other questions is not simply a cookie-cutter, computer-generated mutual fund asset allocation recommendation, but an educational dialogue. Most investors do not have a deep understanding of market history, nor of the factors that drive the price movements of stocks and bonds, and consequently their expectations can be either too optimistic or too pessimistic. We educate you not only about how different asset classes and investment styles have performed in the past, but also about the likelihood of their repeating that performance in the future.

2) Fund Analysis -- It is very easy to select a mutual fund using past performance as your main criterion. Though we certainly consider historical returns, we believe that successful investing in mutual funds requires more thorough analysis. Using both Morningstar and Raymond James’ own proprietary mutual fund research, we look at a fund’s volatility, at the size of its asset base, and most importantly, at the fund manager’s length of tenure and philosophy.

We seek out managers who share our belief that price is paramount when buying a stock, and that stock selection should be based upon an evaluation of a company as an ongoing business, and not just as a stock symbol to be played and traded in the market. In a nutshell, we look for managers who live in “Graham and Doddsville.” If you are not familiar with this locale, in 1984 Warren Buffett gave a talk at Columbia University to commemorate the 50th anniversary of the publication of Benjamin Graham and David L. Dodd’s Security Analysis, the bible for those who believe that rigorous analysis of a company’s financials can give an investor an edge in uncovering undervalued securities and outperforming the averages. The talk was partly in response to those in academia who subscribed to the “efficient market” theory, which says that all information that is known about a given company is already reflected in its market price, and hence the search for undervalued stocks is futile.

In his talk, Buffett profiled a combination of 9 investors or investment organizations who shared an intellectual heritage: they all were direct or indirect disciples of Ben Graham. Buffett dubbed them “The Superinvestors of Graham and Doddsville.” They all had produced superior investment returns, and though some bought large companies and some small, and some bought many stocks and some just a handful, a common theme ran through their work. As Buffett put it:

. . . they search for discrepancies between the value of a business and the price of small pieces of the business in the market. Essentially, they exploit those discrepancies without the efficient market theorist’s concern as to whether the stocks are bought on Monday or Thursday, or whether it is January or July, etc. Incidentally, when businessmen buy businesses – which is just what our Graham & Dodd investors are doing through the medium of marketable stocks – I doubt that many are cranking into their purchase decision the day of the week or the month in which the transaction is going to occur . . . . Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of any interest to them. In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value.(5)

Some might think that given Warren Buffett’s success, and the success of these investors, that almost all mutual fund managers would use this approach. In fact, the streets of Graham and Doddsville are almost deserted. In our research, we have asked many representatives of mutual fund companies if they have any managers who adhere to this philosophy, and with a few exceptions, the question goes right over their heads. Why? Buffett has a good explanation:

. . . it is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately with people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find that you can talk to him for years and show him records, and it doesn’t make any difference . . . . I’ve never seen anyone who became a gradual convert over a ten-year period to this approach. It doesn’t seem to be a matter of IQ or academic training. It’s instant recognition, or it is nothing.(6)

It is also our opinion that another reason why Graham and Doddsville is so sparsely populated is that it is a simple concept, but one whose application involves a great deal of tedious, grubby work. Human nature being what it is, most folks would rather talk grandiose theory and stint on hard labor. Also, humans have always had a fascination for the difficult; as Buffett puts it “there seems to be some perverse human characteristic that likes to make easy things difficult.”(7)

We also stress the longevity of the fund manager’s tenure – not just past experience, but the likelihood that he will remain the fund’s manager in the future. We look for funds where the manager has an ownership interest in the fund management company, or where the management company has a history of retaining fund managers for long periods of time. A study even found that funds which were managed by their namesake significantly outperformed the averages.(8) Though manager tenure is no guarantee of performance, we believe that continuity is an important factor to consider when selecting a fund.

3) Ongoing Monitoring -- Our help with your mutual fund portfolio continues after the initial selection. Because the most important factor in meeting your investment objectives with mutual funds is having the faith that enables you to persevere through trying times, we monitor the fund’s performance, the growth of its asset base, its adherence to its stated style, and the tenure of its manager. Because knowledge and familiarity breed the confidence you need to be a successful fund investor, we emphasize mangers who are able to effectively communicate their views and philosophy to the public, and make sure that you are aware of their thoughts when they are published in shareholder reports and media interviews.

For more information on a fund, please contact your financial advisor for a current prospectus. The prospectus contains complete information on the fund’s investment objective, the risk associated with the investment in the fund, the fees, charges and expenses involved as well as other information about the fund. You should consider this information and read the prospectus carefully before investing.

The investment return and principal value of an investment in a fund’s shares will fluctuate. An investor’s shares, when redeemed, may be worth more or less than their original cost. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Don Harrison and not necessarily those of RJFS or Raymond James.

Keep in mind that there is no assurance that this or any strategy will ultimately be successful or profitable nor protect against a loss.

Footnotes

(1) The Wall St. Journal, “Still Chasing After All These Years”, Ian McDonald, 6/5/2002.
(2) The Wall St. Journal, “Still Chasing After All These Years”, Ian McDonald, 6/5/2002.
(3) The Wall St. Journal, “Still Chasing After All These Years”, Ian McDonald, 6/5/2002.
(4) Davis New York Venture, Quarterly Report, Spring 2008.
(5) The Superinvestors of Graham and Doddsville, Warren Buffett, found in Appendix 1, The Intelligent Investor, Benjamin Graham, p.294.
(6) The Superinvestors of Graham and Doddsville, Warren Buffett, found in Appendix 1, The Intelligent Investor, Benjamin Graham, p.297.
(7) The Superinvestors of Graham and Doddsville, Warren Buffett, found in Appendix 1, The Intelligent Investor, Benjamin Graham, p.300.
(8) Tech Central Station, “What’s in a Name?”, James K. Glassman, 1/21/03.

Raymond James Financial Services | Products & Services | Advisory Staff | Contact Us | Our Mission | Stock Selection | Mutual Fund Selection | Independent Advisor | Commentary Archives | Financial Planning Archives

©2003. Capitalist Investment Services, LLC.
All rights reserved.

Toll Free: 800.717.1848

Securities and investment advisory services offered optional through Raymond James Financial Services, Inc.
Member FINRA/SIPC. Capitalist Investment Services is an independent company.