The Wall Street Journal just published a great article “Is Your Stockpicker Lucky or Good” . The article hits on a point we talk about all the time, backward looking due diligence vs. forward looking due diligence. Investors use backward looking due diligence to try to pick managers who will beat the market, but the real time results are no better than a coin flip. The main reason for this is that backward looking due diligence just doesn’t work, there is a reason that we plaster “Past performance doesn’t predict future results” on everything. Underneath this is the fact that every money manager will have a specific style or strategy and all styles and strategies will cycle in and out of favor. When a manager’s style or strategy is in favor then from a backward looking due diligence standpoint they will appear to have great skill. When their style or strategy cycles out of favor, which it always will, they will appear to have somehow lost that skill.
The solution to this problem from a money manager’s perspective is to be willing to constantly refine your strategy within your style so you can adapt to changing markets. Tactical and go anywhere managers can obviously have an easier time doing this than style specific managers can, but any manager can improve on their process. From an investor standpoint always be asking forward looking due diligence questions:
- Where did your past performance come from?
- Why will it, or won’t it, persist?
- What can go horribly wrong?
- What changes will you make, if any, when market dynamics change?