Monday, June 27, 2011

Article by Joel Greenblatt

Thanks to Steve F. for passing this along.

As most financial advisors know, the secret to successful investing is relatively simple: Figure out the value of something and then — pay a lot less. Unfortunately, as it turns out, it's really hard to figure out the value of a business. And finding good fund managers that can do the job for you — that can be just as difficult. There are several inherent reasons why this is so. Mutual fund managers have to do the things that private investors, such as me, can afford to do. We can own just a few stocks — say as few as 10 to 25 of our favorites — and we can choose stocks that are too small for big funds to buy and for Wall Street firms to follow. Also funds often get too big and charge too much to beat the market. Complicating things further, retail investors — even their financial advisors — are unwilling to hold a good manager when his style is, well, out of style.

Of course, a big impediment to beating the market that all managers must overcome is fees. Most actively managed mutual funds charge fees and expenses based on the size of the fund, usually 1 percent to 2 percent of the total assets under management. This means that the more assets a fund has, the more money the management company makes. As you might suspect, this incentive to gather more assets isn't necessarily good for investors.

To get big and take large positions, fund managers tend to go for big, well-known stocks. But, there can be big advantages to looking at smaller companies. These companies are often too small for large investment funds to buy and for Wall Street firms to spend money on doing research. Less competition from other buyers and less available Wall Street research often mean a greater opportunity to find bargain-priced stocks among these lesser-followed small-capitalization companies. Since there are thousands of companies with market capitalizations below $1 billion both in the United States and internationally, small-cap investors have a big advantage. Being able to choose from thousands of additional choices with less competition from large investors is a luxury that successful investors like Warren Buffett wish they still had. Yet the goal of most mutual funds is to gather as many assets as possible. Chances are that by the time you've heard of a successful mutual fund, it already has many hundreds of millions or billions under management and can no longer take advantage of some of these smaller investment opportunities.


Related whitepaper: The Case for Small & Micro-Cap Value Investing