In Manager Selection, Conventional Rules of Thumb are Dumb
MITIMCo (the group that manages MIT’s endowment) will soon be launching a new webpage for emerging managers. It will describe our approach to partnering with emerging managers, including why we do not ask for GP economics when we anchor emerging managers, and why we commit capital to emerging managers for ten years. Subscribe to this medium page and/or follow me on twitter @joelmcohen to see it when it goes live!
Conventional rules of thumb typically conflict with thoughtful investing. A classic example is the price to earnings ratio. P/E is a very imperfect proxy for discount to intrinsic value, yet investors tend to equate the two. In the recent past, there was a huge opportunity to invest in companies with astronomical headline P/E ratios due to earnings being depressed by heavy investments through the P&L in growth and upgrades to the customer experience. The high P/E ratios scared many investors off, yet these are some of the companies that created the most business value over the past ten years. (It is interesting to note, though not directly relevant here, that P/E was a good proxy for intrinsic value for a very long time, but this has become less and less the case over time. The very fact that it worked so well for so long is largely the reason it continues to be overused today)
It is less often remarked upon, but investing with investment managers is much the same. Below are some of the many silly rules of thumb we see used to the detriment of thoughtful manager selection. We have worked hard to train ourselves to be “organizationally allergic” to these and anything that resembles them.
· What assets under management do you have? What % of AUM will we be? In other words, do other people think you are a good investor? Will I look foolish if you do poorly?
· Do you have any other institutional investors? Who else that seems smart has agreed to invest? Social proof again! Many investors prefer to invest alongside others to reduce the risk of looking foolish. MIT loves firms without other institutional investors! They tend to be the most unconventional and interesting in their approaches.
· How long is your track record? A three-year track record is like a 2–0 lead in soccer with 60 minutes of playing time left to go — not at all bulletproof but enough to give a false sense of security. Yet very often a milestone like this is a trigger for institutions to make an investment.
· Is there a deep organization? Many public stockpickers do not need a team and actually operate most effectively with literally one owner-employee-analyst-portfolio manager. Teams can work too, but we happily back one-person shops where that one person has exceptional judgment and integrity. Especially because with a leaner organization, there is less pressure to raise capital to cover high expenses.
Simply put, in investing we find that most of the best opportunities are found in places where conventional rules of thumb fail.
For us, investing is as simple as looking for exceptional people doing something unconventional that we can understand and that seems likely to generate excellent risk-adjusted returns. If that is a one-person shop with $5 million of AUM, no track record, and no other institutions — but an exceptionally thoughtful approach to investing — great! In fact, that is frequently where we find the most exciting opportunities.
Know of any exceptional investors we should meet who fall victim to typical institutional rules of thumb? We are always looking to get to know unconventional firms who can produce exceptional results in the coming decades.
I can be reached at firstname.lastname@example.org.