"CNBC is a primary source for our stock ideas."
OK, while we haven't heard this exact statement during a portfolio manager interview, perhaps you have learned, as we have, that some investment strategies are more compelling than others.
"Investment edge" is an oft-quoted term by investment managers that loosely translates to "I have a way to beat the market." As a provider of due diligence services, it is a claim that we take seriously and it triggers a natural reaction to dig deeper.
The following line of questions will help you discover if your manager has a defendable investment edge that is truly differentiated and sustainable. To bring this exercise to life, we will profile the LSV Value Equity (LSVEX) fund, which is managed by a team that we believe has such an edge.
Step No. 1: What inefficiency are you attempting to exploit? Is there research or evidence that suggests that the inefficiency actually exists?
The manager's response will likely mirror their philosophy statement. For example, certain managers, including LSV, strongly believe that investors can be emotional and irrational when it comes to financial matters, so they attempt to exploit this inefficiency through behavioral finance and/or disciplined quantitative strategies.
It is important to try to understand why the manager believes that there is a payoff to focusing on this inefficiency. Review the research the manager has done to understand in which economic and market environments their strategy works best, or conversely, fails to generate strong performance. The mere presence, or absence, of this research says a lot about the thoroughness and thought the manager applies to their investment process.
LSV presents historical research that suggests investors have persistently mispriced stocks by forecasting past performance too far into the future, and mistakenly associated good companies with good investments regardless of valuation. Their research is robust, thoughtful, exacting and frequently revisited.
Step No. 2: Does a strength exist as it specifically relates to the manager's ability to identify and exploit this inefficiency? Is there any differentiation or distinction to the investment strategy from the rest of the world?
These questions really get to the heart of whether or not the manager possesses an investment edge. Even the traditional pockets of inefficiency such as distressed securities, spinoffs and micro caps can be picked over. Look for the following areas of strength that can separate a manager from the pack: informational advantages, execution, and experience.
