Cream of the Crop
...excerpt from Mo Lidsky's latest book, Partners in Preservation
Identifying the best-in-class investments is first and foremost about avoiding mediocrity. As a general rule of thumb in investing, if something is not a truly high-conviction opportunity, it is always better to pass. The goal is to identify assets or opportunities that possess extraordinary value, purchased at an attractive price, and that are extremely likely to increase in value over time.
Getting to this point requires a healthy dose of education, nuanced experience, and sophistication. An art neophyte might view Andy Warhol’s Green Car Crash or Claude Monet’s Water Lily Pond and not want to pay twenty dollars for them at a garage sale, whereas an art connoisseur will know immediately that those two pieces are worth a fortune (i.e., $71.7 million and $80.5 million, respectively). A whiskey novice may trade in a glass of thirty-year fine oak Macallan costing over $1,200 a bottle for a strawberry daiquiri because it "tastes better", whereas a connoisseur will appreciate the nuances and detect value. Similarly, an experienced advisor can spot opportunities that sit at the apex of investment offerings, knowing exactly where and how to access them.
At the heart of identifying the cream of the crop is the context. When approached with a long-short equity strategy that achieves 9 percent per annum or a first mortgage that projects 7.5 percent per annum, how can you know what is an all-star opportunity or just an average one? The difference between a good and a great opportunity may be just one hundred or two hundred basis points or simply more favorable terms in the offering memorandum. This difference, however, can provide meaningful protection for investors. It allows them to be somewhat wrong and still make a profit. Identifying opportunities that have a sizeable margin of safety is not easy and therefore achieved by few.
The difference between a Hall of Famer and a forgotten baseball player is just one extra hit in every twelve at-bats (i.e., the difference between .333 and a .250 batting average). The difference between an Olympic gold medalist and a last-place finish is often a matter of seconds. Similarly, in investing, a mediocre opportunity might seem very close to an exceptional one, and knowing which is which requires an ability to understand the nuances of excellence.
This is especially true in non-traditional asset classes, or what are often referred to as alternative investments. Research has shown that there are much wider dispersions of returns in non-traditional asset classes than in traditional asset classes. For example, the top quartile private equity funds far outpace the top-quartile public equity funds. In the same vein, bottom-quartile private equity managers will have profoundly poorer results than bottom-quartile public equity managers.
Someone with a proven track record of picking talented (i.e., top-quartile) investment managers or opportunities should be able to do so in non-traditional and less efficient asset classes where the payoff is richer. However, as wider dispersions create greater potential for permanent loss, if an investor cannot find a best-in-class manager or does not have a high-conviction opportunity in this space, it is better to hold on to the cash.
The last thing to know about making good choices is that there is almost no such thing as a best-in-class financial conglomerate. No matter how well renowned the brand, opportunities and funds need to be considered on an individual basis—strategy by strategy, portfolio manager by portfolio manager. Most large financial institutions or banks are a blend of numerous business lines and products.
An analogy can be made to whiskey where there is a profound difference between blends and single malts. Blended whiskies are fusions of different whiskies from different distilleries. In contrast, a single-malt is a product of one distillery, where you can identify its origin, the cask it matured in, its age, and have the ability to compare or contrast it with its peers. That is why over 95 percent of the whiskies that are sold at auctions and go for significant premiums are single malts. (Even though some 90 percent of all whiskies consumed globally are blends.) Thus despite investors having a relationship with one or two large institutions, that dynamic is unlikely to ensure that one is accessing best-in-class opportunities in every asset class. The products from these large financial institutions will be varied and extensive, but they are certainly not all exceptional. Some may be great, and some may be terrible. Only by focusing on individual money managers, irrespective of which institution they hail from, allows one to identify the best in executing their investment strategy with the ability to outperform their peers over time.