"Buy-Side" Security Analysis
Thomas E. Berghage
The only evidence we have regarding the usefulness of traditional financial analysis as used by “buy side” analysts is circumstantial in nature, but the message seems pretty clear and compelling. It is the actions taken by hundreds of bright well-educated institutional money managers around the country that are constantly looking for analysts that can produce above average returns.
These managers and the analysts they hire generally have longer investment time horizons and are not motivated or compensated by the amount of stock they move. Their performance is evaluated against market performance as measured by one of the popular market indexes such as the S&P500, the Russell 2000, or the Wilshire 5000. Their jobs are often dependent on their ability to produce performance that exceeds one of these indexes. If there were a way for these institutional managers to add value by employing traditional analysis techniques, they would all be jumping on board. The fact is that all of their education and training have not provided them or the analysts they hire with the tools they need to do the job. Given this reality the managers and their analysts have opted to just not under-perform the indexes by buying the indexes themselves.
By adopting this approach institutions and investment managers essentially gave up on security analysis and implicitly accepted the mediocrity offered by Index Funds (Lipper, 1994).
Index Fund Growth
Over the last fifteen years there has been tremendous growth in the number of Index Funds available to the investing public (Figure 5-1). The growth of Index Funds far exceeds that of any other type of investment strategy. In 1988 there were only 12 domestic equity index funds, and they represented only about 1.2% of the entire domestic stock fund domain. At the end of year 2001 there were 254 domestic equity index funds and they represented over 11% of the assets in all equity mutual fund (Figure 5-2).
Figure 5-1
The flow of Dollars Into Domestic Index Funds
(Information provided by the Vanguard Group)
Figure 5-2
Percentage of Equity Mutual Fund Assets
Invested In Equity Index Funds
(Figures Provided By The Vanguard Group)
So why are all of these sophisticated institutional money managers moving assets away from active management into passively managed index funds? The answer of course is performance! When eighty percent of active “buy-side” mutual fund managers fail to beat their benchmark index, one has little choice, but to invest in the index. According to Lipper Analytical Services, during the 10-year period, 1986-1995, only 20% of actively managed equity mutual funds bested index funds. These results are supported by O’Shaughnessy in his book What Works On Wall Street. O’Shaughnessy’s results are depicted in Figure 5-3 where each bar represents a trailing ten-year average of the percentage of active managers that surpassed the performance of the Vanguard 500 Index.
Figure 5-3
Percentage of Mutual Funds that beat the
Performance of the Vanguard Index 500 Fund for the
Trailing 10 years (O’Shaughnessy, 1984)
The story appears quite clear; unless you think you can identify those unique managers that are consistently in the twenty percent that beat the index, you are much better off just going with the index itself. And this is exactly what investors have been doing in large numbers, especially institutional investors.
The problem gets even worse when you look at the twenty percent of managers that beat the index. The majority of those only beat the index by one or two percent. O’Shaughnessy’s data indicates that if you are in search of a manager that can consistently exceed the index by five or six percent you are searching in rarefied air; less than one percent of managers can produce those types of returns. The analysis tools that analysts have been given are just not adequate for adding value over and above market performance.
Institutional investors have been especially attracted to Index Funds because of the huge amount of assets that they must manage. Finding active managers that can consistently outperform the index with large amounts of money is extremely difficult. Many active managers boost their performance by concentrating their investments in a few stock selections. Concentrated portfolios, however, do not lend themselves to investing large amounts of money and they lack the diversification necessary for managing institutional size portfolios.
It is important to understand that Standard & Poors, Wilshire, and Russell Associates all employ financial analysts that used traditional methods of financial analysis in evaluating companies and building their indexes. These analysts conduct a though and complete evaluation of a company before they add them to their indexes. Their use of traditional analysis techniques is probably appropriate, in that they are not necessarily looking for companies that will outperform the market. To maintain the integrity of their index they are looking for companies that represent all sectors and all aspects of their target market. To do this they need to understand the company’s organization, operations, and the business that the company is in. Traditional financial analysis is ideal for that purpose. They are using financial analysis the way it should be used and are not suggesting that they are doing security analysis.
If traditional financial analysis techniques are the only investment tools we have and they are effective and appropriate for building indexes and not very effective for security analysis then maybe, like the institutions, we should confine our investment decisions to the selection of appropriate market, style, and sector indexes. The evidence suggests that our use of the traditional financial analysis tools for security analysis has been ineffective and is inappropriate at best. We will talk more about this in Chapters 9 and 11 where we focus on the future of security analysis.
The inability of analysts, either “sell-side” or “buy-side,” to exceed the performance of random market selections or market index funds suggest that we are dealing with a more basic problem. It is not just the bias or motivation of the analysts that is producing sub par performance, but something more fundamental.
There are many in the financial world that, after reviewing the results of traditional analysis outlined Chapter 3 and 4, would say that the problem is in the time horizon used for forecasting future stock performance. As we saw in Chapter 3 there is little or no relationship between traditional financial measures and stock performance for any time horizon out to and including 12 months. Does this mean that the traditional measures of financial analysis would work with a time horizon greater than one year? Certainly they seemed to have worked for Warren Buffett, the twenty-century’s best investor, who uses an infinitely long time horizon, and rarely sells the equity positions he acquires.
Well what about time horizons that are somewhere between one year and infinity? The only evidence we have regarding the usefulness of traditional financial measures in the three to five year time frame is the circumstantial evidence outlined above. Certainly we don’t want to draw too many conclusions based on circumstantial evidence, but the actions of these institutional investors cast great doubt upon the usefulness of traditional financial analysis. Over the last few years they have moved billions of dollars from active money management to passive market index funds.
More and more public institutions are adopting this passive investment strategy to cover themselves and avoid criticism that they are under-performing the market indices. In so doing, they are actually undermining the very economic system they are hoping to benefit from. If the market is totally random and beyond interpretation, then it no longer becomes an effective vehicle for channeling resources to where they are needed and can be most effectively used to enhance the free enterprise system. If no value can be added by studying a company’s fundamentals, then investors acting in their own self-interest should invest in Index Funds. Then we, as an economic system, have a problem!
Questions concerning the value of traditional financial analysis have been building for many years now. The studies done back in the early 1950s to support the Strong Version of the Efficient Market Hypothesis questioned whether any research was of value and capable of producing excess market returns.
These early studies coupled with the obvious bias of analysts producing investment reports (Chapter 4), provided the building blocks for Modern Portfolio Theory and the use of Market Indices for representing equity exposure. This trend redirected the focus of money managers away from stock analysis and selection, and toward portfolio structure and asset allocation.
In an effort to enhance returns most institutional money managers in the late 1980’s abandoned stock and bond selection and adopted an asset allocation approach. They selected active money managers that used styles that they wanted represented in their asset mix. The problem is that money management styles specified for a particular fund or portfolio tend to drift depending on market conditions. The style drift problem has gotten so bad that Fidelity Investments now publishes in their “Mutual Fund Guide” the style that each of their mutual funds have historically had and what style the manager is now using. Style drift drives institutional money managers nuts. They hire an active money manager because they want his/her style represented in their asset allocation mix, and then find that the manager’s style has changed and their asset allocation is not what they thought it was going to be. This style drift and the inability of active money managers to outperform a bench-mark index has led many in the institutional world to give up on active management and adopt index funds for major portions of their assets
The Universities have done little to help the situation. Their response to the under-performance of money managers is to suggest that markets are efficient and that the price of a stock reflects everything that is to be known about a company’s investment value. This type of academic dogma has spawned elaborate mathematical formulations, but has done little to improve performance.
James O’Shaughnessy’s book, What Works on Wall Street (1997) provides ample evidence that markets are not that efficient and that there is something besides Random Walk and Chaos Theories to describe equity performance. Unfortunately, O’Shaughnessy didn’t venture much beyond the confines of Graham and Dodd. There is a significant gap, often called the area of Complexity, between the order/determinism of Graham and Dodd, and the Chaos/Stochastic models being taught in our business schools. In O’Shaughnessy’s defense, we recognize that his book was written for public consumption and not intended for the Nobel laureates of the Santa Fe Institute.
If you are comfortable with traditional financial analysis techniques and are not ready to make the transition to the new intelligent computer technology described in Chapter 12 then you will be interested in reading about ETFs (Exchange Traded Funds), iShares, and Webs in the next Chapter. The combining of these specialized index funds and the intelligent technology described later may be what is needed to blend the two analysis techniques, the old traditional financial analysis and the new non-linear pattern recognition, into a single system that attempts to use the best of both approaches. We will address these highbred Enhanced Index Funds in Chapter 12.