The opinions and conclusions expressed herein are those of Litman Gregory Fund Advisors, LLC (LGFA) at the time the material is written and may be subject to change.
The following article was originally written to communicate Litman Gregory’s due diligence philosophy and process to users of Litman Gregory’s research service, AdvisorIntelligence (operated by an affiliate of LGFA), and also to the investment advisory clients of Litman Gregory (a different affiliate provides investment management services). Though the article discusses Litman Gregory’s due diligence philosophy and process with respect to equity mutual funds, the same process is applicable to the due diligence we conduct on stock pickers for iMGP Funds. In addition, with respect to iMGP Funds, there is considerable additional focus on investigating each stock picker’s ability to add incremental value by running a highly concentrated portfolio. Finally, the stock picker’s enthusiasm for being part of iMGP Funds is also assessed. The same group of Litman Gregory analysts are responsible for all due diligence conducted by all Litman Gregory businesses.
By and large, both investors and fund professionals rely heavily on past performance in their fund selection process. The problem is that past performance is of little use in identifying funds or managers who will deliver superior future performance relative to their peer group. Numerous studies have failed to unearth a significant positive correlation between past relative performance and future relative performance. The only correlation found has been the consistency of managers with very bad returns to continue to post bad returns in the future. These results are true even if looking at performance of managers within their respective peer groups. So why do investors insist on basing important decisions on data that does not increase their chances for success? There are several reasons:
- Many investors either don’t realize that track records lack predictive value or simply don’t want to believe it.
- The industry, including fund companies, mutual fund rating agencies (with their ranking systems based on past performance), the financial media and many advisors all tout past performance, and in doing so support that fantasy that it can be used as the basis for making successful investment decisions.
- Investors don’t know what else to look for, and may also lack the resources and time to dig beyond the numbers. Historical performance numbers are easy to get and to understand. On the other hand, research that goes beyond past performance numbers is a labor-intensive process that is time consuming, demands experience and knowledge of what to look for, and requires access to fund management firms that most investors and advisors don’t have.
All of this begs the question: Why aren’t track records predictive? First, some managers with strong records have simply been lucky. And eventually, luck runs out. But beyond that, shouldn’t we expect some subset of the best performing managers to be among the most skilled and therefore, as a group, shouldn’t funds with better historical records continue to outperform? Our experience evaluating active managers leaves us less than surprised by the inability of winners to consistently repeat. Our research indicates that even skilled manager’s past success often sows the seeds of their future underperformance. There are a variety of reasons that we have identified as to why maintaining an investment edge is difficult:
- Success results in asset growth. Asset growth may lead to declining flexibility, especially for smaller cap managers, and result in a smaller universe of investable stocks. Even larger-cap oriented managers occasionally buy stocks of middle and smaller sized companies if they are extremely compelling. Also, as assets under management grow, a fund manager may be forced to own more stocks in the portfolio and this may lead to a dilution of their best ideas because they are buying names in which they have less conviction in order to fill out the portfolio. Or, as assets grow the manager may have to own a larger percentage of a company’s outstanding shares, which increases the liquidity and market impact risk if they need to sell the position quickly.
- Success often leads to “stardom” and the temptation to leverage the marketability of the portfolio management team by launching other products. This may force the management team to manage other types of portfolios thus reducing their focus on the original fund. And focus is critically important to winning the investment game.
- Team turnover. Success and stardom may lead the manager or key members of the team to move on to other firms / hedge funds, or start their own. If key players leave a fund, the funds’ prior track record is basically worthless when evaluating the fund going forward.
- As successful managers become spread too thin because of new product and marketing responsibilities, along with the challenge of running more money, they often expand their team, hire more analysts or co-PMs and delegate more responsibilities. While this may be a positive because it deepens or broadens the research effort, new team members may be less skilled or experienced than the original team. Again, this can lead to a dilution of the stock-picking expertise.
- Overconfidence. This is one of the most common problems. Great performance often leads to overconfidence that can result in analytical sloppiness and corners being cut, e.g., the manager may rely more on instinct, gut feel or mental short-cuts rather than doing all the difficult analytical work that contributed to their past success. Overconfidence may also lead a manager to downplay the risks that result from the success traps discussed above. For example, they may be overconfident in their ability to successfully manage a much larger asset base without hurting performance.
The fact that track records are not useful in predicting future relative performance is the basis on which index fund proponents conclude that low cost index funds are the better choice. But we disagree with the underlying premise. The fact that track records are not predictive is not tantamount to concluding that superior future performers can’t be identified in advance. It simply means that the track record does not provide sufficient information to do so. (Does anyone really expect that investment success should be as simple as projecting the past into the future?) Our approach to fund research recognizes that past performance is useful only as a tool for screening funds to identify those that may be worthy of further research. Value added comes from identifying why a fund performed well in the past, determining if the portfolio management team has an identifiable edge (i.e., do we think the past performance was due to luck or skill) and assessing whether the edge, if one exists, is sustainable. Answering these questions requires intensive firsthand contact with fund managers and their research teams.
The Litman Gregory Equity Manager Research Process
Step One: Performance Screens. Our approach to researching equity funds and their stock pickers recognizes that past performance is useful only as a tool for identifying managers that may be worthy of further in-depth qualitative research. So performance screens and quantitative analysis are a starting point in our research process. We consider funds and managers that have outperformed their peer group and benchmarks over a reasonably long period of time. Generally we require a minimum of five years of performance. However, occasionally we will consider funds with a shorter record. We are also willing to take into account a manager’s institutional separate account record prior to the mutual fund’s inception if we believe it is representative of how the existing fund would have performed over the same time period. We have created our own proprietary database of manager returns that enables us to incorporate separate account and mutual fund track records. In addition to absolute performance we take into account:
- Performance consistency, volatility and downside risk relative to the fund’s peer group and benchmarks over a wide variety of time periods (which we can adjust in our database).
- Special factors that impacted performance that may not be repeatable.
- The level of assets on which the record was based (performance generated with a tiny asset base can be a red flag).
- Expenses. We have expense thresholds of 1.2% for larger-cap funds and 1.5% for international and smaller-cap funds. However, we will make an exception for a new fund with a tiny asset base if the expense ratio will fall below our threshold as assets increase.
Step Two: Due Diligence Questionnaire and Document Review. If a fund/manager passes our performance screens and looks promising on a quantitative basis, the next step is for the fund management firm to complete our detailed due diligence questionnaire consisting of about 50 questions. The purpose of the questionnaire is to start to build our understanding of their investment approach and management practices. Our questions delve into the firm’s investment philosophy and process, portfolio management and risk control policies, team members and roles, their compensation practices and incentives, and growth plans. We also read all of the fund’s shareholder reports and manager commentaries going back a number of years, as well as any media articles and interviews that may give us additional insights into their thinking and decision-making process.
Step Three: Initial Portfolio Manager Interview. After reviewing the responses to our questionnaire we always have a number of additional and more detailed follow-up questions, so we set up a phone interview (unless the firm is in the San Francisco Bay Area) with the portfolio manager(s). This is an important part of the process in which we begin to qualitatively assess the manager’s discipline and skill. We ask for many specific examples as we attempt to verify that the manager’s actual practices are in line with how the investment process is articulated in the questionnaire and other documents. We also want to understand the reasoning behind the manager’s investment philosophy and process. We also usually set up phone calls with numerous members of the analyst team to start to assess their quality and contribution to the process.
Often after this initial phone contact we eliminate the manager from further consideration, despite their strong historical performance, due to major qualitative red flags. For example, we may find the manager to be an empire builder, overconfident of their abilities, lacking concern about excessive asset growth or spreading themselves too thin in regards to marketing activities or the number of products they manage. Or we may not be able to get comfortable with the manager’s philosophy or research process, and be unable to see clearly how their past success can be repeated and sustained.
However, if after the initial interviews we are sufficiently impressed with the manager’s investment process, discipline in executing that process, and plans for managing growth, we schedule a visit to their offices, or invite them to visit us.
Step Four: The Site Visit. Our objectives of the site visit are to spend time face-to-face with the manager(s) and also visit with the analyst team and other key investment team members, e.g., traders. We are trying to assess the following (and there is overlap with the initial phone calls):
- Determine if there is consistency between the way the manager describes their investment process and the stocks they actually own. We want to know if the way in which each stock was researched and the justification for the buy decision is in line with the investment philosophy, so we grill the manager about stocks in the portfolio. We also assess their sell discipline by discussing stocks that have been sold and the reasons why. If we find inconsistencies this tells us that either the manager is not disciplined in executing the strategy or their description of their investment process was marketing spin. Either one is a big negative.
- Determine if there is consistency among all team members. By talking to members of the analyst team we can see if everyone is on the same page and gain further clues as to whether the process is executed as described.
- Evaluate the quality of the team. We evaluate how smart, driven, focused, passionate, experienced, humble, confident, performance-oriented, etc. the analysts are.
- Evaluate the culture and compensation incentive systems. We do this to determine how likely the team is to stick together. We believe stability is critical to the ability of an investment organization to stay focused, so we look for firms that have healthy work environments and where everyone is passionate about what they are doing. If there has been personnel turnover in the past, we do everything we can to understand the reasons behind it.
- Understand management’s vision for their business. We want to know how they see the firm changing over time, how the team might change, what other products they might launch, how big they want to get, etc. We understand that all businesses want to grow, but we want to see the desire for growth balanced against a clear understanding of the firm’s fiduciary responsibility to its current shareholders.
Step Five: Final Follow-up and Third-Party Contacts. After we digest the information acquired during the site visit, there are usually some additional questions that require follow-up by phone or email. If there are further questions or issues that can’t be resolved from talking to the manager, we use our extensive industry contacts to do more detective work. Sometimes we know people in the industry who worked with key members of the team at another job or who used to work at the firm we are investigating. At times these contacts are invaluable. We also check firm references (e.g., clients, Wall Street brokers) in situations when we think it will add value.
Step Six: Litman Gregory Research Team Approval. Finally, the lead analyst responsible for covering the fund presents his analysis and opinion at a Litman Gregory research team meeting. (We should note that the team has many informal conversations and meetings discussing the funds we are working on prior to the more formal final meeting.) If the analyst thinks the fund is worthy of recommendation, he must convince the rest of the team. We have lively discussions and debates, with various people playing the role of devil’s advocate, challenging the analyst (in a friendly way) to defend one point or another. This meeting typically lasts a couple of hours, and in many cases it generates a few additional questions/issues for the analyst to follow-up on before a final decision is made.
The research team meeting is an important final step in our investment discipline. The analyst knows he will have to present his case before the entire research team and that people will be on the lookout for any analytical errors, biases or shortcuts in research. Consequently, we have to be very thorough in our research and analysis prior to the meeting.
Additional iMGP Funds Considerations: When evaluating a stock picker for a spot on the iMGP Funds there are two additional considerations. First, we must assess the ability of the stock picker to add incremental value through concentration. Some stock pickers have an edge that can be partly or largely attributed to portfolio management techniques that can’t be implemented with a highly concentrated portfolio. Others simply prefer more diversification. In evaluating this variable we take into account such information as the degree of concentration present in the manager’s standard portfolios, whether the manager has run other concentrated portfolios, the source and degree of conviction with respect to individual holdings, their approach to constructing a hypothetical concentrated portfolio, and additional factors
The second consideration specific to iMGP Funds is the level of enthusiasm the stock picker has for the opportunity to be part of the Funds. We only want stock pickers with a high level of enthusiasm, who, as a result, will be highly attentive to the portfolio and run it as if it were their own money. This is assessed subjectively based on conversations we have with the stock picker.
Ongoing Monitoring: After a fund makes it onto our Recommended list we continue to monitor it. The most important aspect of our monitoring process is a regularly scheduled “fund update” phone interview with the fund’s manager. In these calls we cover significant developments and changes in the portfolio, the team, the firm, etc., and we continue to test our original thesis for recommending the manager. We have in-depth discussions of stocks they have recently bought and/or sold in order to assess whether or not they are sticking to their investment discipline. We also use these interviews as an opportunity to gain further insight into their asset class. Our typical fund update cycle is every six to eight months and the phone interviews typically last 60 to 90 minutes. However, any time there is a significant event, such as the departure of a team member or the addition of a co-PM, we immediately contact the manager to follow-up. In addition, when fund managers and analysts are in the Bay Area they often come by our offices to meet with the research team.
What Makes A Stock-Picking Guru?
What are we looking for in this time-consuming and labor-intensive process? Simply stated, we are looking for managers with an identifiable edge that we are highly confident can be maintained. We’ve found that successful managers with a sustainable edge often possess common characteristics. While not all the managers we recommend possess all of these traits, most of them are common. Specifically this translates into the following:
- The stock picker must have a clearly defined investment process that is also disciplined in its execution. Though there are some highly intuitive investors who are successful, we believe a disciplined process helps to avoid decision errors that result from sloppy, incomplete analysis. We simply have less confidence that highly intuitive stock pickers will be able to maintain their success.
- The investment process must give us a reason for believing the manager has an edge. Sometimes the edge is the level of passion that results in an obsession with knowing companies so well that there is an information edge. Other times the process results in a unique way of looking at companies that can lead to better insights. Some stock pickers gain their edge from a combination of factors.
- We require that the stock-picking team be highly focused with few administrative, business or marketing distractions. They must not be running too many different investment products that may pull them in too many directions.
- We like managers who are independent thinkers, yet able to admit their mistakes and move on. Successful managers do their own research, think for themselves and are often willing to take a position that is contrary to the market consensus opinion because they have conviction, based on their own analysis, that they are right and the market is wrong, and that eventually they will be rewarded for their patience and discipline. Yet, if it becomes apparent that they are in fact wrong and the market is right, they are able to admit it to themselves and sell the position, take their loss and move on. Great investors are also dedicated to continually learning from their past mistakes (as well successes).
- We must be confident that the team will be fairly stable and that business growth won’t be at the expense of returns to existing shareholders. We don’t care for empire-builders.
The Importance of Our Discipline
Just as we demand a clear investment discipline in the managers we recommend, it’s vital that we maintain our own discipline and very high standards. Going through all these steps doesn’t guarantee success. Critically important to mitigating mistakes is our acceptance that not many managers will make the cut. This doesn’t bother us because we don’t need to identify very many great managers. We only need a few. And the reality is there are not that many highly skilled stock pickers out there that have an identifiable edge who we believe will also maintain their focus, team stability and grow their business with shareholders in mind (as opposed to maximizing their own bottom line). So though it is frustrating to spend 30 to 60 hours (or more) investigating a fund company only to decide that they don’t make the cut, maintaining a very high standard reduces mistakes. So we pass on fund companies if we don’t get all the information we need, if our conviction level is not extremely high, if we are not sure if the firm is being straightforward or if we have significant doubts about any of the above keys to success.
The benefits of all this work go beyond significantly increasing our batting average when it comes to fund/manager selection. In addition, it allows us to be patient with managers who go through a slump, as they all do eventually. If one of our recommended funds starts underperforming, we circle back, try to understand what is going on and assess if something significant has changed with the team or process or if we missed something in our initial analysis. If none of the reasons for initially recommending the fund have changed, then we have the confidence (based on our exhaustive upfront research) to stick with a manager who is underperforming for a while, or whose style of investing is temporarily out of favor.
Investors want quick answers. Some quick answers are arrived at by projecting a track record forward without any additional thought. For those who realize the flaws in this approach, buying the whole market at the lowest possible cost (indexing) provides another quick answer. Doing high quality due diligence on stock pickers and fund companies requires a disciplined, exhaustively thorough effort — it is not a quick answer. It is highly labor intensive. But we believe that in doing the hard work that no one else wants to do, we can continue to add value by finding managers who will be able to beat market benchmarks over the long term. And as is true throughout investing, a small edge adds up to big rewards over time.
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