Eat Your Own Cooking

You might avoid eating at restaurants that had chefs who chose to dine elsewhere, wouldn't you?

Apply a similar approach to investment managers: Use the investment managers who eat their own cooking. If a money manager invests his wealth elsewhere, then what incentive does he have to promote the well-being of his clients as opposed to the good fortune of his or her firm?

Unfortunately, few investment professionals have their money invested alongside their clients. It should not come as a coincidence that, over the long term, most investment professionals fail to outperform the market indices. Because this misalignment of interests is skewed to the firm and not the clients, the focus then becomes relative performance versus absolute performance.

This misguided satisfaction with relative performance is articulated best by John Maynard Keynes. He said, "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally." In other words, it's more acceptable to lose money investing with the crowd by paying three-digit earnings multiples for companies like Baidu (Nasdaq: BIDU) than to stand in the minority and own a quality company like NVR (NYSE: NVR) that sells for a single-digit earnings multiple. This flip-sided thinking gets many investors into trouble.

It's also no coincidence that investment managers who have their money right alongside their investors' have usually outperformed the market over the long term. The most obvious example is Warren Buffett, who for nearly his entire life has had more than 99% of net worth invested in Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B). Berkshire has boasted an annualized return of more than 20% over the past 40 years, nearly twice the historical market average.

For those who prefer mutual funds, consider the Longleaf Funds run by value investor Mason Hawkins and his group at Southeastern Asset Management. Hawkins set up Longleaf Funds specifically to invest alongside the fund investors (whom Longleaf prefers to call partners). In fact, employees of Longleaf Funds cannot invest outside of Longleaf.

Consider the first two guiding principles of the Longleaf Funds:

• We will treat your investment in Longleaf as if it were our own.
• We will remain significant investors with you in Longleaf.

Since 1987, the Longleaf Partners Fund has returned an average annual return of 14.45% versus 10.83% for the S&P.

Eight years ago, a fellow in Illinois, putting up $100,000 of his own capital, began a private investment partnership modeled after Warren Buffett's 1950s partnership with $1 million. His goal was to use the partnership as a vehicle to manage the bulk of his family's assets. With 100% alignment of interests, he has produced a seven-year track record of nearly 30% per year with assets under management nearing $700 million. To this day, Mohnish Pabrai continues to remain a significant investor alongside his partners.

Treat individual investments the same way
The same idea works well for individual securities. Companies that exhibit an unusually high level of insider ownership typically are run more prudently and efficiently, which can lead to excellent long-term results. You don't have to worry about the CEO looting the safe when you know that his or her family's well-being depends on the stock doing well in the long run.

Bill Gates of Microsoft (Nasdaq: MSFT) and Steve Jobs of Apple (Nasdaq: APPL), for example, made their fortunes by concentrating their wealth into their companies, and long-term investors have benefited fabulously from the performance of these two businesses.

Investing with individuals who have a 100% alignment of interests with their clients -- they prosper only when you prosper -- is one key step in ensuring that your assets are being handled intelligently and conservatively.

For further related Foolishness:

• Be Greedy When Others Are Fearful
• Are the Homebuilders a Bargain?
• Invest Big in Great Companies