Of donkeys and wise investors: Goodman speaks

What worked in the ’70s can work today — a disciplined investment approach that focuses on buying solid businesses at a great discount to their intrinsic value — according to Ned Goodman, founder and chairman of DundeeWealth.

In an address to the Toronto CFA Society entitled My Perspective, Goodman told an audience of current and aspiring chartered financial analysts that since 2000, stocks have been in a range-bound market similar to what he experienced during his first years in the business managing money with Beutel Goodman.

“I call my process FocusPlus investing. It’s not rocket science, but it requires a lot of discipline and a lot of patience,” he says. “Patience is the most difficult part of the job. Patience is a virtue for donkeys, good husbands and for wise investors. When we find a good business that is run by people with good integrity, and we can buy it at a price that is about two-thirds of what we think its worth, our job is done. From there on in, we wait.”

Stretching back to the pre-dot-com market highs, Goodman points out that the recent bull market has really offered a relatively flat return. He says the trend is reminiscent of the investing period he experienced from 1966 to around 1982, when inflation was high and corporate growth was flat.

In those days, finding yield was difficult because inflation ate a large portion of the gains. Today, the Fed’s interest rates are low, but prices of commodities have soared, devaluing money and making profitability difficult for businesses to achieve. Goodman says this investing climate could prove profitable for the patient investor.

“We are going to live through a period where profit margins are going to be tough, because I think we have a whiff of something called stagflation,” he says. “Beutel Goodman did very well in that environment. We built a business that obtained $15 billion in managed assets between 1966 [and] 1982, and we performed very well during that period. We performed because we were basically valuators of companies, not market mechanics.”

Goodman claims to use the same investment approach today, seeking out companies that are “ugly, unloved, under-owned and undervalued.” He believes this investment approach will always outperform investment styles that closely follow portfolio management theory and the efficient market hypothesis.

He warns this is not a recommendation to start buying today, but the market may offer select bargains in the near future. He says that the markets have likely not yet bottomed out and that the recent plunge by the financial sector is making the markets look cheaper than they are.

For instance, the TSX as a whole is undervalued by about 11%, based on 6% growth projections and a 6% discount rate. That’s still a far cry from his preferred discount of 30%.

“Stock prices today are not expensive, but they are not cheap,” he says.

Recently, his investment process was dubbed “exotic beta,” a style of investing that eschews modern portfolio theory and believes markets are not efficient. Goodman says not long ago he read a Financial Analysts Journal article written by Robert Litterman, managing director of Goldman Sachs, that outlined exotic beta in detail.

“[Litterman] said exotic beta refers to the passive exposure to a risk factor or asset class other than the market portfolio, the market class or the market beta. As such, exotic beta can rely on a largely passive exposure to less mainstream asset classes,” Goodman explains. “Exotic beta is what I do. Exotic beta is what Seymour Schulich does. Exotic beta is what the Beutel family does today. That is, not using modern portfolio theory — it’s working around it.”

Goodman says investors should defy academic conventional wisdom, like modern portfolio theory, the capital asset pricing model and efficient market hypothesis, because he knows “everybody else is using it and trying to make money at it.”

The problem with applying this investment philosophy, though, is the strict adherence to the efficient market hypothesis by many accountants, which Goodman believes has contributed to some of the current troubles faced by the financial sector.

The rise of mark-to-market valuations, which require companies to account for market losses and gains on their holdings, draws Goodman’s ire.

“It’s the principle of market efficiency that provides the academic cover for all that mark-to-market madness that all of our financial institutions have had to eat in the past few months,” he says. “The accountants have done it again. The whole process that has required mark-to-market accounting is basically buying into the efficient market theory.”

Goodman expects this type of accounting to skew financial results further as more international systems of accounting, such as International Financial Reporting Standards, are adopted.

“I’m concerned about how the results of the banking industry are going to be portrayed in the future,” he says.

Goodman is skeptical about the prospects of the financial industry in general, saying a decision by the U.S. Federal Reserve to accept sub-prime-exposed investments as collateral for liquidity loans is more like morphine than a cure for a sick industry.

“It caused Dr. [Ben] Bernanke to panic — and let’s not look at it any other way — two weekends ago, he was in a panic. We were in a crisis of confidence. He had to restore confidence, and he has done so,” Goodman says. “It does not get to the root of the crisis, which is based upon mountains of excess credit of dubious value.”

For now, Goodman says he’s invested in commodities, adding that the boom fuelled by developing economic superpowers should continue for some time.

“We can look at the onset of China and India as another transition that has taken us back to the commodity market,” he says. “We are invested in energy, agriculture, special situations and gold. We are comfortable there, and we are staying there.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(03/28/08)

Mark Noble