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Dan's Reports
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Enronitis
Value managers may protect against accounting tricks

Recent stock market history is peppered with corporate scandals and creative accounting that eventually bankrupted the companies involved and hurt many investors along the way. Names like Bre-X, Cartaway Resources, YBM Magnex, Laidlaw are a few names that reflect some of the same issues facing Enron today. Many criticize professional money managers for missing the warning signs. Is it realistic to expect managers to catch every Enron? If so, what type of manager is most likely to steer clear of such firms?

Baseball and money management

In baseball, offensive players that are successful four times out of ten (a .400 batting average) are rarities that are usually hailed as hall-of-famers. A .300 batting average is considered very good, but that only means a batter gets a hit 3 times for every 10 attempts. Extending the baseball comparison: To be successful, money managers tend to require a "batting average" of about .700 or so. Money managers are human, which means they will make mistakes from time to time. Also, don't be fooled into thinking an unemotional model, such as one driven by a computer algorithm, is the answer.

Investors should expect even the best money managers to miss something from time to time, but as long as they bat .700 or more, they should be successful over time.

Bre-X and the gang

The story of Bre-X has been well documented so I don't need to rehash it here. In summary, Bre-X was a gold exploration company that supposedly found significant amounts of gold in properties it was mining. As a result, many analysts touted the stock as a strong buy. The stock rose so high that it qualified for inclusion in the TSE 300, which caused index funds and all portfolios tracking the index to purchase the stock. (The main TSE 300 qualifiers were how many shares of stock traded each day and the value of all shares traded.) It was later discovered that little, if any gold was actually found in these properties, causing the stock's eventual demise. Sound familiar?

While there were many funds caught with shares of the controversial company, some never even considered it as an investment. As of March 25, 1997 (when the scandal was revealed) funds with the greatest Bre-X concentration included precious metals funds from TD, CIBC, Maxxum, and Bank of Montreal, in addition to small cap momentum funds by AGF (then 20/20 Funds).

Interestingly, some value-oriented managers never touched the stock. Gold bug Jonathan Goodman, who ran the Dynamic Precious Metals fund at that time, never touched Bre-X. His value-oriented philosophy and preference for management with a proven track record of industry performance kept him miles away from this stock at all times.

Value managers

It's no secret that I have a bias in favour of value-oriented managers. The reason is that the mindset of a value manager tends to jive with my way of thinking. When it comes to investments, I'm a skeptic who is often only satisfied with an investment when I can't find anything wrong with it. A similar skepticism guides many value-oriented managers. For this reason, they tend to dig a little deeper for things that could impair a stock's value.

That's not to say that growth managers don't do their homework - quite the contrary. It's just that more growth-oriented managers tend to have brighter outlooks than their stingier counterparts. Value managers' more skeptic point of view means that they often have a different analytical starting point that may enable them steer clear of more scandals than other managers.

Revisiting the baseball analogy: Power hitters tend to hit more home runs and drive in more runs, with more strikeouts. Value managers tend to be more consistent - getting more hits with fewer home runs but also fewer strikeouts.

My opinion is just that - an opinion. It's not based on any research, but rather on my understanding of the general processes followed by different types of money managers. Nobody's perfect, but a fuller understanding of a manager's approach will give you greater confidence in your investing decisions - whichever way you go.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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