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Sound Advice: November 16, 2022

Professional Investment Management ? ? ?

I was taken aback by several recent conversations with ostensibly experienced professional investors.  In the days of yore, investing was a task that required considerable due diligence, primarily about stocks and bonds.  Slightly after the exodus of the dinosaurs, which was when I first got started in the research end of the business, I and my colleagues learned to be immersed in such exciting things as income statements and balance sheets.  The goal of those efforts was to evaluate the future prospects and financial health of the companies being reviewed.

In all cases, we looked for the ability to grow supported by sufficient capital to provide resources for that growth.  The most promising cases were companies that had done well in the past, a trend that one would hope would continue in the years ahead.  An above average rate of past growth was certainly worthy, but from the standpoint of valuation the critical point was the sense of greater confidence that growth would suggest.  The steadiness of growth, not the rate, was the key.

Stock valuations are generally based on growth rates.  The faster the growth rate, the higher the valuation (a.k.a., the price-earnings multiple).  But as growth slows, valuations tend to narrow.  When spans of consistent growth are interrupted by downturns, valuations have a nasty habit of plunging.

The financial side of the equation is an assessment of the balance sheet.  Are finances adequate? Are there heavy borrowings? The answers to these questions are essential information.

In these recent conversations, I listened to colleagues either bemoaning the efforts needed to do a proper analysis or, in the alternative, what I consider questionable approaches to providing professional management services, when in fact they would be considered far short of what should be expected.  The person who shied away from financial statement analysis made it clear that rather than spending endless hours studying financial statements, he’d buy only exchange-traded funds and mutual funds and avoid individual stocks.  The problem with that, of course, is that funds are made up of numerous stocks and/or bonds, so investments in these funds require an understanding of the individual holdings.

That’s not really very hard.  Since most widely traded stocks are followed by numerous well-paid Wall Street analysts, the simple way of getting a handle on growth prospects is to review these analysts’ estimates and projections, which are widely available on sites such as Yahoo Finance and MSN Money.  Similarly, to get a sense of financial health, one-stop shopping requires nothing more than a review of free cash flow, which in Plain English means there’s money left over each year after all expenses, dividends, and debt repayments are made.  If there’s consistent free cash flow, you need look no further.

The other conversations were about extremely simplified investing programs.  One person bought only two holdings: a total stock market index fund as well as a total bond market fund.  The other split the stock fund side into a large cap growth fund, a large cap value fund, a midcap growth fund, a midcap value fund, a small cap growth fund, and a small cap value fund.  That’s like cutting a pie into a number of slices, even though the substance is identical.  Then he added some bonds to make the portfolio look diversified.

Maybe nothing more is needed, but charging a fee for services that could be easily handled on your own seems a bit much.

N. Russell Wayne, CFPÒ


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