Investing in Growth Funds

In the Investing in the Stock Market article we discussed the most successful and least successful strategies for picking your investments. This article is for those with an interest in having a more experienced person perform that role for them. The question addressed here is “How do I find a good fund manager?”

This is an excellent question! Many people say that it’s impossible for mutual funds to outperform the stock indexes long-term. If that were true, then there would be no reason to buy a mutual fund, and this article would be very short!  Warren Buffett’s Berkshire Hathaway has been run like a closed end mutual fund which has significantly outperformed the index for decades! There are several funds available in Canada with shorter, but similar, records of performance!

Part of the reason for the persistence of this idea that mutual funds underperform the market is because it is true of most mutual funds! A typical Canadian bank has over 1500 mutual funds and portfolios available to their clients. I’m not aware of any bank having even 20 good funds. There’s a LOT of junk being peddled – mostly at the branches!

I’ve found that most of the fund managers who consistently outperform the markets over the long-term follow the portfolio management concepts of Ben Graham. How can the investor recognize the use of Graham’s theories by a long-term growth fund?

Recognizing Companies Which Follow Ben’s Rules

Ben Graham developed the basics of portfolio theory. To be a candidate for investment, he looked for certain attributes in the prospective company. A partial list includes:

• an excellent management team with considerable industry knowledge and experience.
• a long-term record of meeting and exceeding financial and strategic commitments.
• participation in an industry forecast to grow over the next 5 years or more.
• an excellent strategy for how the company will grow market share in this growing industry. Such companies have the best chance of huge gains over time.
• a strong competitive position providing protection from competitors easily copying the products offered.
• shares priced below book value to provide downside protection.

There’s a LOT of background information required to evaluate companies to this level of depth. Fund managers who perform well have access to a lot of analysts who have experience working in the industry they analyze, as well as financial training. These analysts take considerable effort to develop and should be valued by the fund management company. The best fund management companies have low employee turnover rates among both Fund Managers and Analysts.

What About the Funds…?

The fund management team described above produces funds which have high commitment levels to fewer stocks than the average fund.  This commitment is shown in 2 ways. 

The Turnover Ratio measures the percentage of fund sales and purchases divided by the total assets of the fund. High commitment funds have low Turnover Ratios. A ratio of less than 50% is good, less than 30% is excellent! Low Turnover Ratios have a significant benefit for the fund’s holders. Fewer trades means lower costs than competitor funds. This should result in slightly lower annual fees (called Management Expense Ratio, or MER). One caution about the MER of a fund. MERs shows how the fund was run last fiscal year. It’s like driving using the rearview mirror. Turnover is updated monthly.

The Top Ten Holdings Percentage shows how much of the fund is committed to the top ten investments the fund has made. This should be at least 50%, and preferably over 60%. Fund managers who truly understand the opportunities from which they are choosing commit strongly to the best ideas! Staying up to date on these opportunities takes a lot of effort, so there can’t be too many. Some funds publish a related number – the number of positions held. More fund management effort is required to stay up to date on larger numbers of holdings. I prefer to see the number of holdings to be below 30, but have recommended some with 40 to 50 holdings in the recent past.

A Last Caution

The concepts outlined here are used by funds which align with your longer term financial goals. They are suitable for your Long-Term Account. Do not use this method for Short-term or Mid-Term accounts