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Profiting From the Failure
of Active Managers
If you were to Google “Active vs Passive Management” you would see a multitude of articles debating the value of high-fee active managers verses low-fee passive ETF sponsors. Instead of sharing our two cents on the fee debate, we would rather spend our time addressing the failure of the models behind most active managers and how to profit from their mistakes.
The reason most active managers fail to outperform their benchmarks is not simply due to their higher fee structure. They fail because they fail to recognize that the markets are random. In their refusal to recognize the “randomness” of the markets, they put their trust in their “expert” ability to predict the future, but the future is not predictable because the markets are random.
That is why Tamco spends zero effort attempting to predict which companies will grow earnings next year. Why spend resources in an attempt to predict something that is unpredictable?
Rather than basing our stock selection on a model that tries to predict the future, we buy stocks based on their characteristics at the time of purchase.
As an example, let’s take the earnings trends of BlueCo and RedCo (below). If these two companies existed today, BlueCo is likely to trade at a high valuation while RedCo is likely to trade at a low valuation.
And the difference between these valuations will be driven by the “experts” and their assumptions about the future earnings of these two companies.
But academic studies have shown that experts are very bad at predicting the future and historical trends tend to revert back to their mean. This principle is called “Reversion to the Mean.”
So the primary focus of our analysis is on the data point of today. What do these companies look like today? What are their current earnings? What are they currently doing with their free cash flow? And how does their valuation compare with other opportunities in the marketplace?
Because today’s earnings and today’s capital allocation decisions give us the best insight into what these two companies will look like tomorrow; and the probability of their earnings reverting back to the mean is higher than most would think.
This type of analysis not only keeps us from overpaying for BlueCo, it also helps us identify the opportunity with RedCo; because there is a reasonable probability that each of these companies will end up with similar earnings and similar valuations over time. And the valuations are likely to be somewhere between where they are each priced today.