September 7, 2009

What's the Prognosis for Passive and Active Management?

Over the last eighteen months, U.S. investors have witnessed a litany of events that most could not have imagined in their wildest dreams--the credit crisis, a near-breakdown of the financial system, massive government spending, bailouts and ownership of private enterprise, a decline in national real estate values, and an unprecedented pummeling of national wealth that has not been experienced since the 1930s. Consequently, the invisible hand of Adam Smith has been supplemented by Uncle Sam's unlimited checkbook. We thought it might be appropriate to take a step back and focus on the U.S. equity markets from a valuation standpoint and see what the implications are for the age old passive versus active management dispute.

Currently, there is considerable debate over whether the recent decline in stock prices has resulted in a great buying opportunity. Moreover, just as much deliberation has centered on which valuation metric to use--price/book, price/trailing earnings, price/forward earnings, enterprise value/ebitda, etc.,--all of which are adequate measures in their own right. Further complicating the matter is whether to use reported or operating earnings in the denominators.

We think a simpler and more intuitive metric to use is the percentage of the total market capitalization of U.S. equities to U.S. GNP. Warren Buffett believes this is probably the best single measure of where valuations stand at any given point in time. Indeed, he has been quoted as saying that when the percentage falls to the 70% to 80% range, allocating capital to equities is likely to work very well for the investor.

If we consider the market cap/GNP percentage going back to 1924, which covers a number of different market cycles and economic environments, the median value has rested at 70% over the ensuing 85-year period. This metric bottomed in the 40% to 45% range during the period from 1940 to 1953, and in the 45% to 50% range during the period from 1975 to 1988, and then spiked to a peak of 190% in March 2000. Recently, even after the threat of financial Armageddon, the U.S. equity market as a whole was reasonably valued at 75% of GNP (the January 23, 2009 estimate) relative to its historical mean. At the trough on March 9 of this year, the percentage dropped to levels that one could categorize as undervalued but since then we have moved back into a more fairly-valued zone. Using the valuation lows in the 1940s and 1970s as a baseline, we see headwinds to further value expansion in an environment where government regulation, intervention and entitlement spending are increasing, interest rates have nowhere to go but up, and corporate profits margins generated by cost cutting are still above their historical median.

The $64,000 question for investors is whether there is any correlation between the market value/GNP percentage and outperformance of active managers relative to passive investing. While there is a plethora of information on the passive versus active management debate, we found very little research relating to this issue. And, while one could debate whether the overall market presents an opportunity for low double-digit or high single-digit returns--which coincidently is far better than what most investors have experienced over the last decade--we think the dislocations in the financial markets, along with the current economic, industrial, and societal shifts, present an excellent opportunity for active managers to add value.

How does one identify these alpha generators? We think there are a variety of factors one should consider. First, we believe those managers that choose not to look like the index have the highest probability of beating the index. With hindsight as our 20-20 guide, did it really make sense for passive investors to have 33% of their large-cap portfolios in tech stocks in 1999, or does it make sense to have 36% of their small cap value exposure in financials, which is where the Russell 2000 Value Index is today? And, given that certain economic sectors are in a state of disrepair, such as the retailers, stock selection can be crucial whereas an indexed approach will buy everything from big-box discounters to high-end boutiques.

In addition, we have seen that managers with a well thought out, time-tested investment process that clearly defines and validates their alpha thesis have a better shot of adding value than those that are chasing the heat of the moment. And while numerous quantitative metrics are used to measure a manager's historical performance, we believe that three of the most important factors are the culture and structure of the firm, and the quality of the people pulling the triggers. Indeed, we believe many investors have too easily overlooked these factors recently in light of their relentless pursuit of too-good-to-be true short-term performance.

J. Gibson Watson III is president and CEO of Denver-based Prima Capital (, which conducts objective research and due diligence on SMAs, mutual funds, ETFs and alternatives.

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