The dance of the hippos

While most of the market players and financial media are focused on the Fed decision and whether it will be good, bad, or indifferent for various slices of the markets, we'd like to take a different tack and focus on our favorite topic, the allocation of capital to well-run and innovative companies.

We believe that one of the major pitfalls for investors of all portfolio sizes is the tendency to focus on "the market" -- the trading price for various items, including equity and debt instruments issued by businesses -- rather than focusing on the underlying businesses themselves.

In the past, we have outlined many of the structural drawbacks to mutual funds -- see for example "Some drawbacks of mutual funds" from May 2008, or "Invest like Mr. Howell" from May 2009. We have always stressed that the biggest problem with the mutual fund structure is its tendency to drive the focus of the investor away from the underlying business and more towards the market.

In fact, the structure of mutual funds can have a tendency to drive the focus of the professional portfolio manager -- the one who is steering the mutual fund -- away from the underlying business and more towards the market as well.

One way that this can happen is by the accumulation of assets under management.

The strength of the mutual fund is that it can give many smaller investors access to a professional manager -- access that they would not otherwise have. It is simply not worthwhile for a professional manager, with all his experience and all the professional research and investing tools at his disposal, to manage a small portfolio of $15,000 or even $45,000. Even if he were to charge a couple thousand dollars a year to do so (which would be a pretty hefty fee in terms of percentage of the assets), he would have to manage an awful lot of them in order to make that pay for itself. Therefore, mutual funds enable the pooling of lots of small portfolios together, into a pool that is large enough to be worthwhile.

However, this strength is also their drawback. As certain mutual funds do better than others, investors seek them out, and today the top ten mutual fund companies manage almost $4 trillion of the total $10.8 trillion invested in mutual funds.

This concentration of assets among the largest fund companies is reflected in the largest mutual funds. In fact, the ten largest mutual funds are all managed by companies in the ten largest fund companies. The assets under management for these largest mutual funds are all in the tens of billions, and this is where the difficulty begins for a mutual fund manager who wants to focus on business fundamentals rather than market factors.

The largest mutual funds (not counting those that are money market mutual funds) currently range in assets from over $239 billion for the largest down to about $54 billion for the tenth largest.

In portfolio management terms, this means that the manager of a fund with $60 billion under management who wants to invest 1% of its funds in a single company is talking about a $600 million allocation of capital (1% of $60 billion). With 1% positions in all of his holdings, this manager could allocate capital to 100 businesses (in reality, portfolio managers hold some percentage in cash, but that is another discussion and for the sake of this example we can ignore the cash position right now). If he wanted to be more concentrated, with 2% positions, he could own 50 companies and allocate $1.2 billion to each one.

Many investors have no idea how few companies exist that can absorb an investment of $1.2 billion or even $600 million. Obviously, a company with a market capitalization of $600 million could be bought outright by an investor with $600 million to invest. This makes it all but impossible for portfolio managers of larger funds to invest in companies of this size (unless they make a tiny investment of a fraction of a percent of their assets, but that is hardly worth while, since even if the company's stock does really well, an investment of such a small percentage of capital will barely move the performance needle at all).

Thus, portfolio managers overseeing large piles of money are forced by necessity to own more and more names, and to own larger and larger companies, simply to find a place to put all those assets. What this means in practice is that these large portfolios typically have more than 100 names, often closer to 200 (and in some cases even more), and each one is typically a company with a market cap of $10 billion or more.

What many investors fail to realize is that there are not that many companies with market capitalizations over $10 billion. The Ford Equity Research database of 4,247 US-listed stocks reveals that, as of the market close yesterday, there were only 356 companies with market caps of $10 billion or more (back in February of this year, when market prices were a bit lower, there were only 299).

If all the large fund managers are owning hundreds of names, and they are forced by necessity to pick from among the same 300 or 350 companies, then they are owning an awful lot of the same companies.

This might not seem like much of a problem, but it does mean that fund managers have a harder time differentiating themselves by selecting superior companies. If you are managing Fund X, and you are competing against your buddy over at Fund Y, you can't say, "Let's each pick different companies, and after five years we'll see who was better at picking innovative, well-run companies." The companies you each select will have a lot of overlap, because you are both forced into the same holdings by the necessity of placing all that capital somewhere.

Therefore, in order to differentiate yourselves, you may say "I will own company Z, and I know my competitors will also own company Z, but during the next 5 years I will own it at the best times to own it, and ditch it at the worst times, and in that way I will beat my competitors."

In other words, your focus may shift from the underlying company itself to the market. You are now interested in owning "slices of time" -- you want to own semiconductors when they are temporarily in the market's favor, and rush out of them the moment they seem to be going out of favor for a few weeks or months.

It should be evident that this type of activity is based more on making market predictions than on trusting in the long-term performance of carefully-selected businesses. We have noted that in his own explanation of his investment philosophy, Thomas Rowe Price rejected the "various systems" for predicting short-term market gyrations and argued for the "simplicity and soundness" of trusting in carefully-selected, well-run businesses.

What should investors do to base their investment discipline on a more business-focused footing? We've argued previously that investors can become their own investment managers, selecting individual stocks and bonds -- see for example here, here and here.

Those who are not inclined or not able to take on investment management duties themselves can search for professional management that can demonstrate a business focus in their investment process. Avoiding mutual funds by no means guarantees one is avoiding the "mass-managed money" problems described above; in fact, many "separately managed accounts" offered by large investment management firms have as many assets under management as mutual funds run by the same firm -- or even more assets than their brother or sister mutual funds. Similarly, some smaller mutual fund companies offer funds that do have a business-focused investment process. We discuss selecting an investment manager in previous blog posts such as this one, this one, this one and this one.

We believe that this is an important and little-understood concept among those not in the portfolio-management business. Please be sure to share it with your friends and family.

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