Thursday, May 15, 2008

Four Out of Five Wrong

Morningstar touts its own services in a recent How to Find Bargains in Today's Market that outlines “5 Ways to Spot Cheap Securities”. So what is the problem? Four of the five points are absolutely wrong and will only help investors under-perform the market. Let’s take a closer look at the five assertions and why investors should never “follow these points to the letter”.

1) Home in on cheap stocks

“Find those companies that are trading at well below the prices that our equity analyst team thinks they're worth.” The majority of these companies are trading at a discount for a reason; the firms are suffering from industry challenges, mismanagement, or other significant headwinds. Statistically 70% of these companies under-perform over the upcoming 2 and 5 year periods. Just because a company trades at a discount to theoretical value does not mean it is a good investment, in fact many are absolutely horrible.

2) Identify index mutual funds and exchange-traded funds that hold cheap stocks

Remember how well this strategy worked from 1997 to 2001. There are many other time periods where “value” under-performed. Many times an index mutual fund or ETF holding stocks that are selected simply because of their cheap valuation are merely holding a basket of market under-performers. While it is important to consider low expenses in your fund selection, any focus on “cheap” underlying stocks over the potential of the holdings is misguided.

To the second sub-point, many times ETFs and mutual funds trade at a discount to their associated index. Many times this situation continues for years. Knowledgeable investors look for changes from the historical statistical mean of the standard discount as a signal to buy or sell; they do not simply purchase an ETF or fund because it is selling at a discount.

3) Check out newly reopened funds

Usually the reason that funds are re-opened is because they have horribly under-performed and thousands of investors have fled with their cash. Usually these funds are also sizeable meaning it will be hard to correct their course moving forward.

The concept that investors should hunt for reopened funds is dreadful advice. Generally only actively managed funds which do not have a large amount of assets outperform the market. Investors would be better searching for funds with good managers that are not large in size (in terms of total assets).

4) Investigate target-date funds

Target-date funds are designed to allow large mutual fund families to double dip. First they get fees from the under-lying fund and then from the “target-date” fund. Multiple write-ups have called these funds a “pyramid of fees” that are bad for investors.

Investors are better off to understand basic portfolio diversification, and select a set of low-expense funds that meet their needs. Utilizing target-date funds is just asking to be socked with higher expenses.

5) Consider tax-managed funds

There is some benefit to tax-managed funds so this point is not entirely off-course. However many would argue that it is more important to focus on performance over tax-savings in your investing; coupled with the reality that many holdings are kept in tax-free accounts such as 401Ks and IRAs.


Morningstar comes across as trying to create an article that is merely designed to tout their service offerings. Not that the information services that Morningstar provides are bad, I use them myself for both stock and mutual fund research. Unfortunately most of this pitch is laced with advice that should not be heeded by investors. This serves as a typical example that many articles in the financial press are just simply veiled marketing ploys for services or financial products, and the advice given is not always in your best interest. As always, buyer beware.