The past two years, I've had the distinct pleasure of attending the Motley Fool's annual writers conference dedicated to, naturally enough, superior investment ideas. That's ultimately what each and every article you'll read on Fool.com is focused on, and it's certainly what I aim to deliver with each issue of my Motley Fool Champion Funds newsletter service. It's always great to come together -- as John Lennon once sang -- around such an important concept, one that unites all of us as investors.
Take it away
There have been lots of (if you'll pardon the expression) "takeaways" from the conferences, but for me, the highlight of the 2005 soiree was an eye-opening presentation by New York University biz school professor Aswath Damodaran.
Collected in such tomes as Investment Fables and in such scholarly periodicals as The Journal of Financial and Quantitative Analysis (you didn't let your subscription lapse, did you?), the good professor's work can be pretty rarified at times. Nonetheless, I left his session seriously educated, amused, and enriched. The guy can tell a joke, and his lecture had a good beat. You could dance to it.
All kidding aside, anyone who cares about the integrity of financial accounting -- and, more particularly, about the myriad assumptions that underlie seemingly straightforward valuation metrics such as price-to-earnings (P/E) ratios -- should tune in to Damodaran.
57 varieties
For example: To put one of his key insights way too simply, there are 57 varieties of the P/E ratio, and if you invest in part (or, heaven forbid, even in whole) based on whether a stock looks "cheap" relative to the company's earnings, at the very least you'd better know which flavor of P/E (trailing, current, or forward, to name but three) you're basing your valuation assessment on. Otherwise, you're comparing apples to kiwi fruit.
Another cardinal Damodaran concept is that of the "companion variable" -- that is, the other essential factor in light of which every price multiple needs to be understood. For example, a stock may look like a blue-light, bargain-bin special on a price-to-sales basis, but if the company is in a commodity business with profit margins that are razor-thin, the stock may actually be expensive, not cheap. Margin, in other words, is a companion variable for price to sales. Without it, your valuation picture is incomplete.
Deconstruction of the fables
That's also true when it comes to making buy and sell decisions based on industry-specific price multiples. Yes, IBM
Similarly, while Time Warner
Indeed, following Damodaran's ideas, "deconstructing" each of the market's sectors -- not to mention the industry-average multiples that so many investors rely upon for valuation purposes -- becomes relatively light work.
But what about me?
To be sure, there are nits to pick in Damodaran's work, but what, ultimately, do his important ideas mean for a friendly neighborhood fund analyst like me or, for that matter, investors like all of us?
Good questions, and at first I was scratching my head, too. This is all very interesting, but how might Damodaran's insights have an impact on the kind of number-crunching work that I do?
After all, I'm more attuned to data about manager tenure, expense ratios, standard deviation of returns, and R-Squared, a figure that allows you to gauge how much of a fund's performance can be explained by movements in a given benchmark. I'm also inclined to gauge the performance of actively managed funds relative to that of low-cost index trackers such as Spiders (SPY) or Vanguard 500 Index (VFINX).
But then the light bulb came on.
Where were you when the lights came on?
Whether in taxable accounts or through tax-deferred vehicles such as 401(k)s and IRAs, more than 90 million of us are invested in mutual funds. And as even a cursory glance at the Champion Funds discussion boards indicates, a good many fund investors are smarter than your average bear -- or your average bull, for that matter.
Foolish fund investors are concerned with intelligent asset allocation, and they're well-accustomed to thinking about fund "styles" -- i.e., where a fund falls on the market-cap and growth/valuation spectrums -- as they go about the business of putting together a well-diversified portfolio of picks plucked from such categories as "large growth" or "small value."
But here's the thing
A fund's categorization reflects the average price multiples of its underlying portfolio, multiples I examine closely while doing research for Champion Funds. For me, then, Damodaran's observations about stock valuations dovetail nicely with a point I've made early and often to our newsletter's subscribers: Not all large-growth funds (to pick just one category as an example) are created equal. Categories aren't monoliths, and to the extent that you operate as though they are, you're missing out on important, market-beating opportunities in your 401(k) or other mutual fund investments.
Here's an illustration:
I firmly believe that large-cap growth is the most undervalued area of the market right now, and since the newsletter's debut back in 2004, I've recommended six funds that fish in that particular pond. Thing is, each of those funds hews to very different stock-picking and portfolio-construction strategies.
One manager, for example, runs quantitative models to assemble his portfolio. Another is run by a growth-at-a-reasonable-price (GARP) investor, and a third is run by a team with a decided preference for discounted growth companies.
The short story is this: As with price multiples, there are huge differences among funds that get lumped together in the same category. Therefore, smart, Foolishly well-advised investors should slice and dice seemingly sacrosanct groups like the iron chefs that they are -- at least, that is, if they aim to serve up market-beating returns.
This article was originally published on Feb. 15, 2005 under the title "Deconstructing Fund Categories." It has been updated.
Shannon Zimmerman is the lead analyst for Motley Fool Champion Funds. You cantest-drive his newsletteron a completely risk-free basis. He (and you) will be glad that you did. Shannon owns shares of Tribune. Time Warner is a Stock Advisor pick. The Motley Fool is investors writing for investors.
