Is purloining good ideas distasteful? U.S. fund manager Mohnish Pabrai doesn't think so. He says it's a great way to make money and urges people to copy notable investors more often. You might want to take a page out of his book and improve your portfolio.
Mr. Pabrai recently talked about the joys of being a copycat with students at the Ben Graham Centre for Value Investing at the Richard Ivey School of Business in London, Ont. He pointed to the case of McDonald's, which is well known for spending a great deal of time and effort on selecting locations for new restaurants. The effort is worth it because a good spot can make the difference between success and failure. But rival Burger King has a less expensive approach. It simply puts its restaurants across the street from existing McDonald's locations, thus getting the benefit of its rival's research for free.
The case for copying extends into the realm of investing where it makes up the core idea behind indexing. Just like Burger King, indexers see little reason to pay fund managers large piles of cash to pick stocks. Instead they buy what everyone else is buying while trying to pare costs to the bone. Some might characterize indexing as a parasitical approach but it is also a highly successful technique.
While there's nothing wrong with indexing, Mr. Pabrai believes smart stock pickers can do even better. He urged students interested in the market to follow the best investors in the world and said Warren Buffett was a good person to emulate. After all, Mr. Buffett is famous for his record as the CEO of Omaha-based Berkshire Hathaway (BRK.A, BRK.B). Thousands of investors pack a stadium each year to hear his words of wisdom at the company's annual meeting.
How would someone who aped Mr. Buffett's stock picks have done? Gerald Martin of American University and John Puthenpurackal of the University of Nevada, Las Vegas, did the calculations in their 2008 paper, Imitation is the Sincerest Form of Flattery. If you had mimicked Mr. Buffett's stock portfolio – with your trades occurring a month after Berkshire publicly announced each move – you would have beaten the S&P 500 by an average of 10.75 percentage points a year from 1976 to 2006. In other words, you would have made out like bandit.
Unfortunately Mr. Buffett's big run may be coming to an end. After all, he is 81 and won't be around much longer. He also runs a staggering amount of money, which leaves him little room to manoeuvre when searching for outsized profits – most investments are simply too small to move the dial for a company as gigantic as Berkshire. Even Mr. Buffett agrees that his performance will moderate in the future for this reason.
So how about copying somebody else? That can work, but only if you keep an eye out for problems. Many portfolio managers are more than happy to talk about the stocks they hold. But some might not have your best interests in mind. Managers may talk up stocks they're keen to sell with the idea of giving them a little boost.
It's better to verify what a manager is doing rather than what he is saying. Thankfully, everyone gets to peek at what fund managers do via regulatory fillings. Using those filings, you can calculate the prices at which a stock was purchased to make sure that you're not paying more than the manager you're copying. You can also keep an eye out for new additions or removals. Websites such as gurufocus.com and dataroma.com can help you with these efforts because they regularly track the portfolios of famous investors.
But there's another hitch. Managers who trade frequently may have swapped into different stocks soon after they filed their list of holdings. Someone who jumps into stocks on the basis of those regulatory filings could be purchasing stocks the manager has already discarded.
For that reason, copycats should focus on investors who hold stocks for long periods. By and large, that means copying value investors – money managers who buy out-of-favour securities and hold onto them for several years.
Value stocks tend to outperform for surprisingly long periods after they're purchased. In the latest edition of his book Contrarian Investment Strategies, U.S. portfolio manager David Dreman explored the results that come from the classic value investing approach of buying stocks with low price-to-earnings ratios.
To demonstrate the efficacy of this approach, he looked at two portfolios: one composed of glamour stocks with P/E ratios in the highest 20 per cent of the market, one composed of value stocks with P/E ratios in the lowest 20 per cent of the market.
Mr. Dreman compiled these portfolios for each year, beginning in 1970. He tracked their results over two-, three-, five- and eight-year holding periods
As you can see from the accompanying table, the long-term results for value stocks were excellent. For copycats that's good news: It means that copying a value investor's portfolio can yield good results even for those who don't jump on a stock pick immediately.
If you're interested in copycatting, you might want to start by checking out Mr. Pabrai's portfolio. (You can also see a video of his talk at bengrahaminvesting.ca.) According to dataroma.com, his top 10 holdings at the turn of the year were: Wells Fargo (WFC), Berkshire Hathaway (BRK.B), Potash Corp. of Saskatchewan (POT), Terex Corp. (TEX), Goldman Sachs (GS), DIRECTV Group (DTV), Horsehead (ZINC), CapitalSource (CSE), Citigroup (C), and Bank of America (BAC). With any luck you'll get good returns and avoid paying performance fees while you're at it.
The Fab Five
You might want to take a few good stock ideas from the portfolios of these famous investors:
Norman Rothery, PhD, CFA is founder of StingyInvestor.com