A recent experience in Cancun got me thinking about how investing has changed over the years and how it has put the average investor at a disadvantage. I was sitting in a Starbucks when a little girl approached me. She couldn’t have been more than eight years old. Her arms were adorned with a couple of dozen bracelets and other trinkets she was trying to sell. As she came up to me, she pulled off a unique-looking bracelet that appeared to be a lion or jaguar made of beads. She wanted 20 pesos for it which is the equivalent of one dollar.
I wanted to help the girl out, and that seemed like a good deal, but I didn’t have any pesos. All I had were twenties along with a $2 bill I always keep in my wallet. I told her to wait while I got some change. I returned to the Starbucks counter to buy another drink, but they didn’t give change in pesos. In fact, they didn’t give any change at all, so I had to use my credit card to pay for the drink.
I returned to the little girl who was still holding the bracelet, and, not wanting to disappoint her, and not wanting to give her a twenty, I reluctantly handed over my Thomas Jefferson $2 bill. But she didn’t know what it was. I tried to explain in my broken Spanish that it was a very special kind of currency—very valuable. But she didn’t bite, saying she could only accept pesos. So, I kind of shrugged my shoulders and took my two Starbucks drinks, and left.
Missed Value, Lost Opportunities
Later, as I was thinking about that little girl walking away from my $2 bill (the equivalent of 40 pesos), I couldn’t help but think about how investors do the exact same thing—walking away from great investments because they don’t recognize value when they see it.
A lot of that has to do with how investors today perceive value. Whereas we see value in the business, its cash flow, dividends, and capacity to compound growth over the long term, an increasing number of investors place a higher value on a company’s market liquidity—how quickly they can get in and out of a stock.
Whereas our emphasis is on small- to midsize- companies that offer tremendous long-term value whose stocks trade on low volume, their focus is on stocks with high trading volume, which tend to be the more prominent “headline” stocks. While it may take us much longer to get in and out of a position because of low trading volume, they find comfort with high trading volume knowing they can get in and out quickly, without regard to the company’s underlying fundamentals. In doing so, they miss out on the tremendous values that present themselves in the broader market, of which there are plenty.
Big Money Pressure to Own Market Movers
This shift towards a trading mindset can be attributed largely to the concentration of capital among fewer investment managers. You can’t manage a hundred billion dollar fund the same way as a hundred million dollar fund. With that kind of money, you need to be in larger, more liquid stocks to be able to move in and out of different equities.
Investors looking to outperform the market want funds that invest in market movers such as Facebook, Apple, and Google. Fund managers who want to attract more capital need to show their investors they’re buying market movers, so many will “window dress” their portfolios with big-name stocks for the quarterly reporting period. They need to move out of those stocks quickly if they begin to drag down portfolio performance. Between their high trading costs, taxes, and management expenses, many of these funds fail to outperform the market.
Index funds present the same dilemma for investors as many actively managed funds. Market-weighted index funds are highly concentrated among over-valued mega-cap companies like Facebook, Apple, and Google, which means they aren’t nearly as diversified as they think. And, there is not much value to be found among the widely followed stocks in the S&P 500.
Thoughtful Investing vs. Hoping for a Winner
It’s unfortunate because there is real value to be found in the stock market, but you have to know where to look. There are great, well-managed companies in the small- to midsize range that fly under the radar. Their daily trading volume is not very high, which means it’s not as easy to move in and out of the stock, but that’s not why investors own them. We own these companies because they have demonstrated the capacity to generate lots of free cash flow and compound it over time to spin off tremendous shareholder value.
If you want to be in the stock market, you must decide if you are an investor—looking to compound returns over time through thoughtful investing or a trader hoping to latch on to a hot stock or fund. With more than 25 years of professional investment experience, I can tell you that hope is not a strategy, and you are bound to miss out on a lot of $2 bills along the way.
