The Globe and Mail, Report on Business
Published September 22nd, 2006

Because I'm starting a new mutual fund company, I've had the opportunity to sit down and talk to a lot of money managers over the last few months. I've seen all shapes and sizes - from one person shops to large, multi-product investment management firms. I'm looking specifically for what I call "absolute-return" investors; that is, portfolio managers that are totally focused on buying securities that are undervalued and will make their clients money. They-re not worried about industry weightings on the market indexes or what style box they fit in.

If I had to generalize about these meetings, I'd say they went "clink, clink, clunk". In all cases, the investment process was well established and pursued with discipline (clink). The people were experienced, scary smart and passionate about what they were doing (clink). But, the outstanding track record I heard so much about turned out to be pretty average and in some cases, down right lousy (clunk).

How did that happen? I know that smart people with a defined process don't always produce good results, but I'd heard these managers were at the top of the heap. Somehow they've gone from being stars to being forgotten, or worse yet, to being labeled as dogs.

This, of course, is part of the investment management business. Nobody can be on top all the time. It can take just two years - one average and one lousy - to take the luster off of a good long-term record. Today's stars are all candidates to be tomorrow's dogs. In reality, it's a fine line between the two categories. A couple of stocks in the portfolio that either go to the moon, or conversely become complete busts, can have a large effect. A timely bet on one sector or market theme can meaningfully impact ten years of performance.

Over the course of the past year, it's amazing how the performance standings have changed. It comes down to the fact that the capital markets have been influenced by a few powerful and long-lasting trends. These trends, which have gone to extremes, serve to exaggerate the differences between the stars and dogs. It's like turning up the sensitivity on your computer mouse or going from level one to three on a computer game.

Let me illustrate.

For investment managers charged with managing a Canadian equity fund, their world has been defined by three important trends - the commodity boom, a rising Canadian dollar and the focus on income. Get them right and you're golden. Get them wrong and you're heading to the doghouse.

There are lots of managers that don't believe commodity stocks are a good investment. They view these companies as being profit challenged and subject to huge cyclical swings. If they did own them, they were bought as value plays (when they were losing gobs of money and nobody loved them) and they've long since taken profits. Given what's happened in the Canadian market, those sales have made for a very tough year.

The rising loonie has an impact on all kinds of things, but for an equity manager who uses foreign stocks to fill in the holes in his/her Canadian portfolio (as I've pointed out before, our market is pretty small), the impact has been devastating. Even a manager that's made some great U.S. stock picks has nothing to show for it in Canadian dollar terms.

The focus of individual investors on current income (yield) has also had a profound impact on the standings. It has produced excellent returns from income trusts and high-dividend stocks, which in turn has made these types of securities more expensive and therefore of little interest to the absolute-return investor.

In hindsight, I shouldn't have been surprised that these managers were not at the top of the charts. We've been in a raging bull market for commodities and high-yield securities and any benefit from holding foreign stocks has been wiped out by our strong dollar. It's not been a good environment for managers who are intensely focused on valuation and are not attuned to riding the trends. The search served its purpose however. I've found some terrific managers and it provided a stark reminder that good long-term performers have bad years too. Indeed, their returns are often defined by how they behave when they're out of synch with the crowd.

So before you get your violin out for these down-trodden managers, remember that they will again have their day in the sun. Perhaps, the markets of the last two weeks have helped them turn the corner and poke their nose out of the doghouse. In any case, the next time I visit this topic, I'll no doubt be writing about the "revenge" of the absolute-return investor.