Beware the one-metric approach to investing

Don Phillips, managing director for Morningstar, encourages investors to ask multiple questions. Is a moat sustainable? Do new competitors alter the landscape? Are the people and practices that built a fund’s record still in place?
By Morningstar Analysts |  08-01-19 | 
 

A college friend once asked me for an investment tip. She and her husband had had some financial setbacks and were behind in building their retirement nest egg. I recommended a low-cost broad-market index fund and encouraged her to be diligent in saving and investing future monies in it.

After looking into my recommendation, she responded that the historical returns on the index weren't really what she had in mind. What she needed was something that could double or triple within a year, but without a lot of risk, as they had had prior financial problems and couldn’t stomach future losses.

I'm sure most everyone in financial services has a similar story about the unrealistic expectations of their friends or clients. We all want the impossible — weight loss without diet or exercise, the miracle, one-stop solution to our problems. Sadly, our search for such panaceas can blind us to the merits of perfectly good solutions staring us in the face, as was the case of my college friend who I suspect passed on my recommendation — a recommendation that if followed would have put her family on firm financial footing, given the extraordinary progress of the broad US equity market in the decade since I made the suggestion.

What's true for investors in general is also true of our attitude toward individual data points. Too often we want each data point we have for a security to tell us all we need to know about the investment. If it fails to do that, we toss it aside and move on in our search for the holy grail — a single statistic that will instantly tell us if an investment is wise or not. In the process, we risk jettisoning valuable insights and limiting our prospects of ultimate success — just as my college friend did hers.

I've seen this numerous times at Morningstar when we introduce a new metric, such as our sustainability measures or our style box innovations. Inevitably, someone will suggest that we link these insights to performance numbers and try to create something predictive of future success, something that gives investors that magical simple solution to their search for great investments. The intent is admirable, but the results seldom bear fruit.

Even if a new metric doesn't tell you everything you need to know about an investment, that doesn't mean it doesn't tell you something of value. Wise advisors will be careful not to lose these nuggets of gold just because the pan also contains some gravel. After all, small insights systematically built up can lead to great decisions. Such is the case with our economic moat work. I've met investors who want wide moats to be a panacea. "Buffett buys wide-moat companies. If I do, too, I will have great results," goes the logic.

Unfortunately, it’s not that easy.

Our analysts have done terrific research into which companies have developed economic moats, what sources those moats come from, and whether their moat is trending up or down. It’s a powerful research insight and one that wise investors will treasure. But simply having a moat does not make a company a buy.

Price/fair value is an essential counterpoint to our moat analysis. Even great businesses can be overpriced. Indeed, our analysts frequently identify 1-star wide-moat companies.

Moreover, there is reason to suspect that wide-moat stocks in aggregate will not generate the highest returns. After all, these tend to be superior businesses, and investment theory tells us that bigger, stronger companies should produce lower aggregate returns than smaller, dicier ones — hence, the small stock premium.

But that doesn't mean that a wide-moat status offers no investment insight. Indeed, it still has great utility.

A wide moat is like an insurance policy against calamity. In most years, it won't come into play, but when things get rough, it is wide-moat companies that have the greatest staying power. Just look to their superior performance during the 2008 financial crisis. That is a virtue that any wise investor would seek to incorporate into their portfolios. Knowing if your stocks are linked to wide-moat businesses doesn't tell you all you need to know about them, but it sure tells you something worth knowing.

The same, of course, is true for our fund star ratings. Knowing that a fund has delivered superior risk- and cost-adjusted performance historically doesn't tell you that it will be on next year's leaders list, but it does suggest that the fund likely has below-average costs, takes reasonable risks, and has more-seasoned management — all insights worth knowing. I'd never suggest the stars offer a full conclusion, but to suggest they can’t contribute to the debate is misguided.

Just because a data point doesn't answer all your questions, doesn't mean it shouldn't be in your arsenal for consideration. Take each insight for the positives it brings to the table and keep asking more questions. Is a given moat sustainable? Do new competitors alter the landscape? Are the people and practices that built a fund’s record still in place?

Successful investing is about accumulated insights, not panaceas. Smart investors prize metrics for what they surface, rather than deride them for what they can't.

This article originally appeared on Morningstar.ca and in the December 2018/January 2019 issue of Morningstar magazine.

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