Consider the following assertions. Market-cap-weighted indexing blindly buys stocks with no regard to valuations. Active managers, on the other hand, calculate the intrinsic value of a company and then buy only if the price is below that value. Is that really true? I find this line of thinking troubling in part because it seems so simple. If Berkshire Hathaway’s Charlie Munger is right in his statement, “Anyone who finds it easy is stupid,” then there has to be more to the story, don’t you think?

Let’s unpack the first assertion: Index funds blindly buy stocks with no regard to valuation. This statement is really made from the standpoint of an accountant rather than an economist. (As a CPA, please know that I’m not belittling the importance of the accounting profession!) From an economist’s perspective, price is an incredibly powerful mechanism in the markets. It represents an agreement between buyers and sellers whereby both parties benefit from the transaction.

Consider Frank, a farmer who’s selling broccoli to a customer, Laura. Frank has invested a lot of sweat, equity, and capital into his farm and is looking to trade broccoli for money, which he will use to buy rice to diversify the dinner he’s serving to his family. Laura is looking for a fresh, healthy complement to the chicken she’s cooking for dinner. The price the two parties agree upon represents the point at which both Frank and Laura are able to accomplish their objectives. At the aggregate financial market level, prices contain a huge amount of information about how buyers and sellers view the value of all the securities in the market.

Now let me put on my accounting hat and take this down to the next level. The price of any stock is the sum of the current earnings of a company and a multiple that represents the market’s view of where those earnings will go in the future. The forward-looking nature of stocks implies an inherent level of imprecision. Some buyers and sellers will be wrong. As this occurs over time, multiples change (sometimes dramatically). And, of course, earnings change over time based on both company-specific and macro-economic issues.

With that, we can now neatly turn to the second assertion and the crux of the issue: Active management is valuable because it focuses on the differences between intrinsic value and prices. If my previous statements are even partially true, then prices are actually pretty smart things—they represent many, many different views of intrinsic value. The assertions we started with suggest that active managers are somehow separate from the “market.” In reality, they’re critical market players—they are, in fact, the Frank and Laura’s buying and selling, thus incorporating their views into the price of various securities.

When active managers say they’re looking at differences between intrinsic value and prices, what they’re really saying is that their model of intrinsic value differs from price. There are a few important points here. First of all, no model is perfectly correct. In reality, valuation is a rather complex exercise that’s very useful (and very fun in my eyes!) but nonetheless based on a myriad of assumptions and forecasts. Second, a given active manager’s model represents one view.Blog_Chess_02192016

Market-cap weighting is powerful precisely for the following reasons. It builds a portfolio of securities using price and therefore all of the different views and valuation models of market participants. Active managers are not outside observers who work in a different market than index funds. And outperformance does not result from simply running a model and observing that the valuation that comes out is lower than price.

Active managers and index funds are not really analogous to a chess master (active) playing against a child (indexing). Rather the situation is more analogous to predicting the future. Can it be done? Sure, but it’s tough and you’re really going to need the right circumstances. In the case of active outperformance, these circumstances include low costs, a disciplined process, and patience.

Note:

  • All investing is subject to risk, including the possible loss of the money you invest.