Adding Value through Opportunistic Investments

However bad the markets are, there are always pockets of opportunity somewhere. And even during bull markets, when sensible investors won't buy expensive stocks, there is likely to be something cheap if you look hard enough.

In 1999, when tech and growth companies were selling at outrageous multiples, value stocks were going begging,³ as were nontech small-caps and real estate investment trusts. In 2007–2008, when the credit crisis was in full bloom and markets were on the verge of their worst collapse in a generation, they were practically giving away closed-end bond funds.

Unfortunately, though, too many advisory firms seem brain-dead when it comes to finding nuggets of gold in a mountain of dross. Once, when I was serving on the investment committee for a well-known university, a committee member asked the university's advisor if he had any interesting investment ideas. “Well,” said the advisor, “I saw in the Wall Street Journal that the smart money is buying blue chips.”

The reason so many advisors wouldn't know an opportunistic investment if they tripped over it is simple—most advisors aren't investors. They are consultants, brokers, client service professionals, and so on. There may be a small army of analysts somewhere in a back room, but those people are (a) too young to understand investment value, and (b) focused on manager diligence, a very different thing.

For institutional investors, this may not be a big issue. Many institutions have their own in-house investment staff, and virtually all have investment committees, often full of savvy investors. Also, many institutions actively avoid making opportunistic investments, for fear they won't work out. The institutional mind-set tends to be to get to the target asset allocation and stay there by rebalancing every quarter. As many people have noted, institutions would rather fail conventionally than succeed unconventionally. Still, because rebalancing necessarily involves selling high and buying low, it works reasonably well over time.

Unfortunately, it doesn't work well for families, who have to pay taxes (and higher transaction costs) every time they rebalance. Because families can't take as much advantage of the magic of rebalancing as institutions, families need other arrows in their quiver, and one of these arrows should be opportunistic investment ideas.

That means, of course, that families need to engage an advisor who isn't brain-dead when it comes to sniffing out interesting values. But how can a family find such an advisor? I've devoted a separate chapter to the important question of hiring the right advisor, so I'll cut to the chase here. You hire a good investor by asking good investment questions during the interview process.

Unfortunately, most families ask questions like, “How many analysts do you employ?” These families are apparently unaware of the fact that most analysts are engaged in doing low-level diligence on money managers. Families ask, “How many managers do you follow?” as though quantity weren't the enemy of quality.

Instead, consider assessing a financial advisor they way you would assess, say, a multistrategy hedge fund. No one much cares how many analysts a hedge fund has, but only how good they are and how well they are being trained working under senior portfolio managers. No one cares how many opportunities a hedge fund manager is looking at, but only the quality of those opportunities.

And those are the kinds of questions a family should be asking of potential advisors. What is your process for identifying interesting investment opportunities? How well structured is that process? Do you implement your ideas yourselves or via external managers (or both)? How do final decisions get made about which opportunities will be pursued? How do you size opportunities?

Unfortunately, few families ever ask such questions.