Nobody feels ambivalent when it comes to the advisor's role in picking stocks. But what exactly are we talking about? Students of Benjamin Graham--who counts Warren Buffett as one of his star pupils--will point out that they are not actually picking individual stocks, but are more likely choosing individual companies in which to invest--a different matter entirely. "When the subject of stock picking arises, everyone always points to Warren Buffett and his success," says Glenn Kautt, president of The Monitor Group Inc., a McLean, Va. wealth management firm with $500 million under discretion. "But Buffett picks companies, not stocks, which is actually harder to do."
Kautt points out that Graham, an investment guru in the1930s and 1940s and the author of Security Analysis (first published in 1934), said that you have to become familiar with the companies and analyze their securities before investing. Graham's book was considered the first true "investment oracle," and its simple tenets and sage advice were followed closely by many of today's multi-millionaires, including billionaire Buffett.
"Even with information transparency these days, there are still going to be 10,000 people picking over the same data you have, all at the same time, jockeying for position with you," Kautt says. "That's why picking a winner is so unlikely. If you are basing it on information you've gathered, it cannot happen; it is a statistical accident if it does."
The wealth managers at The Monitor Group do not pick stocks, Kautt adds, nor do they use actively managed mutual funds whose investment philosophy is "picking individual stocks because of superior performance." Kautt's attitude mirrors that of many other wealth managers across the country. In his opinion, stock picking is merely gambling or at best, he repeats, a "statistical accident."
"There is no credible evidence by independent researchers that shows that actively managed mutual funds or professional investment advisors who pick stocks actively outperform passive indexed portfolios over a long period of time," says Kautt. "There are many studies on this subject, and one of the most recent was conducted by Savant Capital Management in Rockford, Ill., and Zero Alpha Group (ZAG)."
Founded in 1995, the Zero Alpha Group is an international network of nine independent investment advisory firms--including Kautt's Monitor Group--that manage close to $6 billion in assets. Members of the group are committed to providing objective, long-term, private wealth management solutions to investors, focusing on asset allocation and a structured, quantitative approach to investing. The firms in the Zero Alpha Group network share a common philosophy about investing and client service--a commitment to passive, tax-managed investment strategies while providing an independent financial planning solution for investors. The ZAG Web site--www.zeroalphagroup.com--features the most recent published reports.
One, published in March 2006 and entitled "Hidden Bias in Morningstar Data 'Systematically and Significantly' Overstates Managed Mutual Fund Performance," talks about a type of "survivor bias" in actively managed mutual funds. Kautt cites this report as further evidence that stock picking and actively managed mutual funds are not good for clients. The hidden bias was noted by the Zero Alpha Group, which reported that this bias led to an "overstating of the performance of actively managed mutual funds relative to their related indexes for the 10-year period from 1995-2004."
The statement goes on to quote report co-author Brent Brodeski, managing director and a financial advisor at Savant Capital Management, who says: "The mutual fund industry systematically and significantly overstates fund performance in a way that makes actively managed mutual funds look much more competitive with indexes than is actually the case."
"To my knowledge, there are no credible independent academic studies in support of stock picking," Kautt says. "Even when we examine the investment portfolios of Nobel Laureate economists, by and large all are passive indexed funds. This has not been refuted."
"Frankly, I've been in this industry 25 years, and I'm almost 60 years old," Kautt continues. "The older I get, the less confident I am that I'm picking the right stock. With experience, comes humility. But so many advisors think they must have 'sexy' programs, such as separately managed accounts or alternative investments to attract big money. Our latest client is worth more than $40 million, made all his own money, and has a financial planning company attached to his previous firm. He came to us because of our disciplined approach to passive indexing. Our clients are usually people with a net worth of $7 million or more, and let me tell you, they don't want 'sexy,' they want wise investing."
David Yeske, one of two principals in Yeske Buie in San Francisco, Calif. and Falls Church, Va., agrees with Kautt that stock picking is not a good idea for his wealth management company, either.
"The main reason I don't pick stocks is that I don't actually believe I can add value to individual stock picking," Yeske said. "No one can. I believe the market as a whole is going to give us the best answer available at the time, and it is really our best guess. The stock prices that are set in the market are the collective wisdom of all investors. For a single individual to think he or she can outsmart the system...there's some pride there, and you know what they say about pride."
Yeske says the stock market is in itself a "system," and he does not think he can add value to that, but with other wealth managers, he notes, "hope dies hard."
"I assemble individual portfolios using indexed funds from Vanguard and a lot of funds from Dimensional Fund Advisors, and they give very focused exposure to small caps and market stocks, and in that way, they add value," Yeske says. "They have a methodology for concentrating a portfolio on value stocks or on small caps or on micro-caps--whatever focused exposure is chosen."
If clients have their own ideas about how they would like to invest their money, Yeske and his managers suggest a small "play account" that they can deal in on their own. "I call it giving outlet to their desire to gamble," Yeske said. "There's nothing wrong with gambling--I just don't do it myself. However, if they want to dictate to me how to invest, I send them elsewhere. I'm not a stockbroker, and I don't take direction from my clients. If they want a broker, they can go to Charles Schwab or TD Waterhouse or another firm."
Even with transparency in the market, Yeske's view on stock picking is unlikely to change. "Sure, there is a great 'sizzle' factor with stock picking," he says, "but I can't do it just to entertain my clients. Transparency doesn't remove uncertainty. Stock prices change based on new information; information enters the market randomly; prices move randomly. All this is cancelled out with a broadly diversified portfolio of stocks. Our portfolios beat the market all the time. For my money, the collective wisdom of the markets is hard to beat, and especially not by a single individual claiming to have a system for picking stocks."
Paul Kenworthy, principal of Palisade Asset Management LLC in Minneapolis, Minn., says he picks individual companies, not individual stocks.
"I look for businesses when I want to own over the long term and don't want a lot of fluctuation," Kenworthy said. "I'll learn everything about a company, and often we know more about the company than its employees. We're more likely to eliminate a company from our investments if we don't like how they do business."
Kenworthy says artificial categories abound these days, and companies inflate earnings as a matter of course. "Sometimes it's their accounting practices that make it seem their earnings are greater than they are," he says. "For example, Enron reported profits that were a present value of things that had to happen in the future. I never owned Enron because their earnings were always so unbelievable. But the point is, it is so easy to fudge on these earnings reports, that the plethora of information that is readily available may not be helping matters much when it comes to stock picking."
If he doesn't feel comfortable with a company, Kenworthy does not invest. "It doesn't always work in my favor," he acknowledges. "For example, I never wanted to own Google. I couldn't understand it. I don't have to invest in everything, though."
Indexed funds are anathema, Kenworthy adds, because managers have to buy the bad companies along with the good.
"In the late 1990s, Wall Street was taking companies public that had no sales or earnings," he adds. "I don't mind investing in a startup company when the valuation is $5 million to $10 million, and if it works, the upside is up to $100 million. But when Wall Street was trying to sell us multi-billion-dollar valuations for startups, I could not understand it. As I said, I don't have to invest in all companies if I don't feel comfortable."
So many wealth managers "blindly look at quarterly earnings, "says Kenworthy, "but I like to look at the actual companies. I look for situations where the management has respect for customers, employees and shareholders. If it's all for the people at the top of the food chain, what's the point in investing?
"I certainly don't need to convict people; I'm not a judge or a jury. But if I don't feel comfortable," he reiterates, "I just don't invest."
On the other hand, he believes that equity investing can be an effective way to make a statement. "Some people who have a lot of money think they can only have influence with their charitable contributions. We can have an influence on the world with our investments, too," he adds. "I like to visit the actual companies and see the people who run [them]. Too many people have no clue who's in charge or how the management system works at many organizations."
Kenworthy believes two huge categories of businesses are experiencing major management problems that will eventually impact stock picking and/or managed accounts: financial services companies and telecommunications companies. "These categories of business have no regard or little regard for customers or employees. Respect for employees is important, too," he says. "Banks wanted to be growth companies, so the top people can take out millions of dollars. They don't deserve repeat customers or shareholders."
Kenworthy says some wealth managers are not going to pick stocks because they don't have the information they need to do so.
"The advantages of stock picking are that the investors have complete control over taxable events, such as when you take gains or losses," Kenworthy says. "And you pay a lower level of fees, because you're eliminating that middle manager from the mix. You can really individualize portfolios with stock picking, too."
Kenworthy even has some clients with whom he works "like partners."
"Some of our clients are very experienced and can tell us companies that they like or don't like," he says. "There are many medical device companies based in the Minneapolis area," Kenworthy continues, "so I have a little more of that in my portfolios these days. I have two doctors as clients, for example, who are very astute and are heavier investors in medical areas and device companies, and they often share articles with me from some of their medical journals. We also invest in private companies that do not trade publicly."
Many clients pick their own stocks and then run them by Kenworthy and his eight employees for their approval. A few years ago, the CEO of a billion-dollar company was solicited with an offering document to invest in Globetrotters; he showed the document to Kenworthy.
"I told him he wouldn't like the terms, and he asked me to go talk to the principles and negotiate different terms," Kenworthy recalls. "I did, and you can do that when you are dealing directly with the issuer. If I didn't like it, though, I would not have invested my client's money. It's that simple."
Kenworthy says he learns more about evaluating companies from Warren Buffett's 25-page letter to shareholders than he does from the news media's constant coverage of stocks and the markets. "Certainly, information is more readily available than ever before," he concedes. "But these shows are worthless to me because their information is based on the idea that everyone is operating like a day-trader. That's not investing; that's short-term speculating," he asserts, "and I don't do that."
Working with individual clients and picking individual securities is the old way of doing business, he adds. "You have to enjoy this, and if you're a student of business and have the capability to find out about companies, then this will work for your company. It's probably easier for companies not to pick stocks," he adds, "but people used to spend more time on this way of investing. The idea is to buy businesses you like and stay with them over the long term. Evaluating management is key to this philosophy."
Another wealth manager who picks individual companies is Jeff Fishman, founder and principal of JSF Financial LLC in Los Angeles. "We do pick individual companies for certain clients who want to have highly concentrated positions," Fishman said. "Sometimes we have clients who will transfer money into individual equities, or sometimes they choose out-of-favor stocks that might one day represent good opportunities for growth."
These individual companies are usually riskier than the rest of the client's portfolio, Fishman adds, but it still fits with their overall plans. "These chosen companies can maintain a sizeable position in the account, and more than anything else, you have to focus on it. It may need 'stop sells' or 'covered call' writing or 'pushes' to protect the position."
Fishman doesn't consider investing in individual companies "a gamble" or "play money," since it can be a large investment for many.
"These accounts take a lot more time and a lot more detailed work for us, depending on the client's tax status," Fishman notes. "You really have to pay special attention to these individual equity accounts."
JSF Financial employs 15 people, one of whom is in charge of "picking stocks," Fishman says. "He heads trading for us and oversees the accounts with individual equities. We always have clients who will suggest that they want to invest in particular companies. It's our job to have to manage the client's expectations. This takes communication skills. You have to ask them, if it doesn't work out, how much do you want to put at greater risk? They have to clearly understand the risks."
Fishman says he doesn't think increased transparency in the marketplace means that much, since most people investing in equities are chasing higher returns. "They're balancing greed versus fear," he says. "Up to about the year 2000, people wanted to put more money in individual securities, but after taking huge hits from 2000 to about 2003, they lost their appetites for individual stocks. Most people have decided that slow and steady is more prudent."
Since so many investors have a bad taste in their mouths from losses incurred during the late 1990s and early 2000s, Fishman says most individual investors are looking for reasonable returns with some stability over the long term.
"If the markets fall, they want to have some downside protection," he explains. "In that way, the markets have changed from the 1990s. The previous attitude was, if it goes up 20, I want to be there and in on it. Now the stance is, if the market falls 20, they don't want to fall with it--at least not that much."
It is important, he emphasizes, to inform clients and have a conversation about risks and possible returns.
"As a wealth manager, you have to be able to facilitate these accounts," Fishman says. "If you don't have the resources, refer it out. If you are not able to provide the proper advice, you will just get yourself in hot water. Any independent brokers like Ameritrade or Schwab can do this for your client if you can't."
Fishman adds that if a wealth management firm is truly providing for their clients, they have to be able to meet their diverse needs, even if it involves choosing individual company securities.
"At the very least, you should have someone on staff who can have an educated discussion with your clients about what they want and what they hope to gain from choosing individual equities," Fishman says.
However, it is probably needless to say that if what clients hope to gain is a quick killing from a start-up "guaranteed" to be the next Microsoft, it may be a fortune-teller they need--not a financial advisor.
Marian Chang (email@example.com) is a freelance business journalist and feature writer based in Reno, Nev. She wrote about angel investing in November 2006.