Passing on Passive

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July 8 marked the 125th anniversary of the Wall Street Journal, and a number of luminaries wrote articles about the future of their fields. One article, by John Bogle – the founder of Vanguard Group and champion of passive/index investing – pointed out that 34% of all U.S. funds are now index funds and said the trend toward them will accelerate. The benefits of indexing are obvious – low cost, low turnover (read: tax efficient), diversification and performance that mimics the averages. Unfortunately, over longer stretches, about two-thirds of active money managers underperform the indices.

If it’s “middle-of-the-road strategies” (Bogle’s description of index-based investing) you’re after, then that’s the route you ought to take. However, it’ll be a sad day when we all decide to embrace mediocrity.

I was attempting to conjure analogies to best explain how my firm and other value investors strive to beat the market, when I glanced back to a previous page in the same section of the Journal. There was the perfect analogy. Billy Beane, general manager of the Oakland A’s, is baseball’s leading “active” manager and the baseball equivalent of a value investor. Beane, who is now widely known from the book and movie Moneyball, picks players who are unrecognized, underrated and therefore undervalued, whose skills can be acquired at a fraction of the cost of more-recognized ballplayers. The A’s payroll is well below that of other franchises, yet its record tops the majors.

This is exactly how one should approach investing.

For your baseball team, you wouldn’t want an aging player whose salary is based on an excellent track record that’s not replicable. Similarly, a stock that’s trading above fair value should be avoided, especially when there are alternatives that can be embraced.

The Moneyball concept has other analytical applications in the investing world. Much like with sabermetrics (data analysis to compare ballplayers), one can utilize technology to screen for undervalued companies and find those that are trading at discounts to fair value. Large-cap stocks tend to fluctuate between 80 cents-on-the-dollar and fair value, and they typically close the gap fairly quickly. Owning undervalued large-cap stocks can be highly rewarding when they reach fair value, often getting growth in the business while you wait and collecting a dividend along the way.

Here is the recipe to beat the market over time: First, buy low and sell high – or better said, buy cheap and sell expensive. A discount from fair value provides upside potential, and buying bargains typically contains downside risk since these positions have already fallen – they offer a “margin of safety,” in value investing parlance. Holding excellent companies for the long haul is a solid strategy, but buying cheap ones, particularly if they’re sound companies, and selling them when they reach fair value has been shown by countless backtests to provide the highest returns. Finally, if you can hedge, or short the market to protect your positions when a recession is upon us or during a bear market, you will have the best of all worlds.