Market busters

So, it must seem like a cruel taunting of the bull to publish a book on top stock pickers just as the bear’s roar deepens. Or is it? Vancouver-based advisor Bob Thompson has met up with some of his favourite money managers, and declares it’s not the manager’s style that is important, but the discipline. Styles have their cycles too. Yet, despite what appears to be an unbeatable efficiency in markets, certain styles have, at least in an academic sense, demonstrated their worth in picking up what alpha is missed by the general market movements. But discipline remains key.

“A sad fact is that many, if not most, individuals who have invested with the best money managers have not made a lot of money in the process. Why?” Thompson asks. “Because most investors, high-net-worth or not, make the wrong decisions at the wrong time. They sell a great manager’s fund because of short-term underperformance, without looking at their portfolio as a whole. Smart money managers don’t suddenly become stupid; the style simply goes out of fashion for a period of time.”

It’s useful to remember that. It’s hard to beat the market. Despite the rise of ETF investing in Canada, and to a lesser extent, index funds, there are many money managers who think they can, but few do.

Over the years, a variety of measures have surfaced to determine whether, over the long term, there is any appreciable managerial alpha. And yet, academic studies have demonstrated three persistent sources of market beta: value stocks, small-cap stocks, and momentum stocks. Two of these three market factors can be harvested systematically, in the quantitative fashion espoused by Jim O’Shaughnessy, for instance. There are others who attempt to reap the rewards of the more volatile momentum factor in a disciplined fashion.

THOMPSON’S FAVOURITES
Thompson, a long-time observer of hedge fund strategies from his perch as a financial advisor at Canaccord in Vancouver, has collected his interviews with a selection of managers who follow these style disciplines in a book, Stock Market Superstars: Secrets of Canada’s top stock pickers (Insomniac Press, 2008). While his own philosophy is to capture returns by a blend of value and growth styles of investing, using volatility as an opportunity for rebalancing, he is attracted to long/short and arbitrage strategies that, in theory, smooth stock market volatility. But he’s mostly interested in the process of investing – and the lessons learned from the mistakes his favourite managers have made.

That’s not for everyone. Some might say that value and growth styles can be achieved in a marketcapitalized index. Others might lean more to the value side or the growth side (which is almost, but not quite always true for small-cap stocks). Still, Thompson manages to convey the essence of managers whose long-term results are well ahead of the indexes by letting them speak their piece.

TRACKING THE MANAGERS
But where are these managers? Mostly running their own shops. Rohit Sehgal is the only fund manager associated with a big mutual fund company that he’s interviewed: in this instance, Dynamic Funds. In a sense, the exception proves the rule: exceptional managers are not to be found in large organizations – at least not ones so fearful of tracking error that they are ruled by index-hugging criteria. Certainly, that’s one spin one could put on Thompson’s book, and it’s a pertinent one, since there is a raging discussion about how active active managers really are.

T h o m p s o n tends towards some of the scariest money managers – in a good sense. There’s Tom McElvaine, formerly with the Cundill organization, whose motto was to invest: “When there’s blood on the streets.” McElvaine is equally cognizant of panic: “We deal in nightmares, not dreams,” he says. He hangs on to stocks almost forever – because it takes that long for Mr. Market, the moody character created by Ben Graham, to recognize their value. By the same token, he doesn’t feel the need to swing at every pitch. While he looks at intrinsic or breakup value and the volatility of his estimate of that value and management quality, he is also looking for a buyer’s market, making purchases when there is no hope and then selling when hope abounds.

And yet, it’s not always a buyer’s market. Wayne Deans, for example, attributes his performance over the past half-decade to the fact that there were so many attractively priced companies. Still, he notes he learned a lot more by making mistakes – in the late 1960s and early 1970s – than he did by doing things right. Like many of the managers Thompson interviews, he tends towards companies that have attracted very little in the way of analysts’ interest. Then again corporate bonds are priced just as inefficiently, thanks to a perception that high-yield debt is junk.

Then there’s Tom Stanley, whose idea of diversification is to hold eight stocks in his Resolute Growth Fund. His equities are not just unpopular, but unknown and unfollowed. He has an 18-point investment philosophy. But perhaps more pertinent is his view, taken from Sir John Templeton, that a money manager can outperform the market simply by being different from the market.

Thompson covers some of the better-known voices in investing, such as Eric Sprott and Frank Mersch as well as Sehgal. But the lesser-known voices also deserve attention, with this caveat: Many are in the small-cap space. Apart from Deans and Stanley and McElvaine, they include Irwin Michael (ABC), Allan Jacobs (from Sceptre to Sprott Asset Management), Front Street Capital’s Norm Lamarche, Peter Puccetti at Goodwood, Randall Abramson at Trapeze Asset Management and Vertex’s John Thiessen.

BANKABLE INSIGHTS
In a book of interviews, there’s bound to be bankable insights. One, from Irwin Michael, is that a degree in child psychology might offer insight into understanding markets. Surprisingly, for a deepvalue manager, he does use technical analysis to time his entry and exit points. Another is that portfolio management is quite unlike professional sports, where an athlete reaches a peak in his or her late 20s. Portfolio managers are just starting out at that point, reaching the height of their discipline two or three decades later. Perhaps it’s that sort of experience that allowed Michael to note that, when Nortel was trading at $124.50, it had a book value of $11, half of which was goodwill – or “air.”

Randall Abramson, at Trapeze Asset Management, accepts the value label, but not the cigarbutt approach to investing: the metaphorical practice of picking stocks from the gutter. Instead, like Warren Buffett, he argues that a stock isn’t valuable unless it’s growing. The firm uses Strategic Valuation Analysis (SVA) to find companies with efficient balance sheets – neither too much leverage nor too little. SVA also produces buy and sell signals, which Abramson argues prevents a manager from getting out of a stock too early (or buying too early). Interestingly, Abramson says that if active management is supposed to add 100 to 200 basis points over index returns, the timing model should add another 100 or so.

Some of the stock pickers are better known for a particular kind of exposure, rather than a style. Front Street’s Norm Lamarche, for example, specializes in junior resource plays. With them, Lamarche says, the quality of information and management are key. Like a surprising number of Thompson’s stock pickers, Lamarche worked for the Bank of Canada, initially on the big-picture items that affect interest rates, among other things. So his funds do have themes that trigger the bottom-up analysis of individual companies.

A contrast is Peter Puccetti at Goodwood. With little resource exposure, Goodwood instead has been regarded as a catalyst investor: buying a concentrated portfolio of beaten-up stocks and pushing management to shake up the company. Still, Puccetti says he tends to sell too early – a fate of many a value manager. On the other hand, Puccetti also suggests that he may be buying too early, but then, he tends to start with small positions until he can see how a company will unlock its intrinsic value.

Selling early is one thing Allan Jacobs, now at Sprott, tries to avoid. For him, one of the biggest investment mistakes is cutting the winners while hanging on to the losers. But he also has a fairly large number of names in his portfolio, with 50 to 70 stocks. Still, he has held many stocks for more than a decade, arguing that if it’s a good company, a stock may fall but only because the market has fallen. Indeed, in the small-cap stocks where he invests, some of the lowest-risk names have produced the highest returns.

Another relative unknown is John Thiessen who, along with Jeff McCord, runs Vertex Management. Vertex is started off in merger arbitrage plays, as a hedge fund manager also known for a value orientation, looking for underregarded stocks like Canada’s one Triple-A rated stock: Imperial Oil. One of the merger arbs that did come to pass was the Weyerhaeuser takeover of MacMillan Bloedel. The investment catalyst here was that if a company that old was selling itself, it must have been certain that it actually wanted the deal. And, like Puccetti, Vertex is moving into shareholder activism. Another shared strategy is shorting companies likely to go bankrupt.

It is not possible to summarize a 400-page book with more than vignettes that point out some of the similarities – and some of the differences – among successful managers. Right now may not be the most opportune time to show case stock pickers, Thompson admits. Then again, it may be. Warren Buffett’s buying. And people study his words to find out about his investment discipline. But there’s more than one Warren Buffett – Thompson’s 12 managers – though certainly not predictive of future performance – nevertheless offer much about how discipline has worked in the past, and how it might work in the future.