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The Value of Intellectual Capital:

In a continued environment of competitiveness, economic opportunity and goal of financial freedom; many investors seek to put their money to use by investing in capital markets through varying degrees of skill, expertise and abundant approaches that promote or promise success. Regardless of an individual investor’s reasoning for DIY (Do-It-Yourself) investing, we routinely equate a specific portion of our overall return of investing to skill, discipline, approach or luck rather than attribute those returns to the general direction of the market. Some DIYers will see obvious benefits of investing on their own without professional guidance while others will seek the challenge of applying individual strategies that they feel offer an edge against the market’s average returns.

But what is the value of our individual or collective intellectual capital? There are masterful investors both in public and private circles of investing, but what can an individual without exposure to significant material or financial resources hope to accomplish in adding value to their return? My contention has always been that although there are limits to individuals due to such resources, many investors can excel by applying a sound investing discipline in order to take advantage of the simplest of intellectual capital. That might appear unrealistic to many, but from my personal experiences I’ve seen amble evidence to indicate that opportunities exist through the application of discipline that holds the potential to increase returns that outperform the market. The problem exists of how you measure this added-value; is the calculation of an alpha ratio appropriate, can historical returns matched against a benchmark or index fully reveal the complexities of a specific investing strategy? Having invested on my own through an individually designed investing discipline for only a short time, I have limited evidence of the long-term impact of this belief. I have to confess that my age restricts the ability for me to provide results over any long period of time since backdating of such an approach is increasingly difficult from my own research. Yet my hope is that by sharing some thoughts, arguments and my routinely “think outside the box” approach to investing that I can maintain an open mind of the reader into considering the points I make.

My own definition of intellectual capital is the combination of many qualities or characteristics that give an investor a better understanding of their scope of practice and enhance their ability to succeed. The intellectual capital I apply in my career is general in all areas of health, but highly specific in emergency medicine. I have strengths and weaknesses in various areas of my individual practice, but for the most part I stick to what I excel at doing best as I learn. Someone can try to test my knowledge on paper to quantify a specific measure of this capital, but unless you’re in the trenches of such an activity, the evaluation doesn’t necessarily match the intended purpose perfectly

An investor has the same ability to perform based on their experiences, understanding, knowledge, insight and control of emotions in the intent to achieve a higher return. Intellectual capital doesn’t necessarily come strictly from book or street smarts, but a combination of both knowledge and experience in doing something over a period of time. Although an investor may not succeed individually each year against a personal benchmark, an argument stands that they serve a better chance at success by being on their own than simply joining the market in its inevitable average returns. Although a mainstream strategy may be appropriate for the masses, I question whether it meets individual personal needs enough to justify the pros and cons of the strategy. No one will ever manage your money as effectively as you; simply because your objectives are not identically the same as everyone else’s. You may not have a desire to control the investments you hold, but that doesn’t always translate into someone else managing your money more effectively.

It’s important to understand that the market is not just the sum of all returns, but of all activities. The assumption is that of all the investors in the market as a whole, each individual is responsible for specific market movements; yet each investor isn’t individually responsible for the same impact or share of activities. When you account for pension funds, mutual funds, private equity groups, hedge funds and now exchange traded funds that are invested in the markets you are left with a pool of activity that represents far fewer than 50% of individual investors. Examining the Dow Jones Industrial Average as an example; the average for each component owned by these institutions is 66%. One could even suggest that over half of the movement of the DOW collectively as an index, and each stock individually, in any given year is directly responsible by the trading of this group of investors.

Following the same pretence you can suggest that if over 50% of the markets movement during any given time frame is responsible by this group of large institutions, then behaviour is increasingly important in relation to everything else. In strategic management we refer to these behaviours as group-think: “an act or practice of reasoning or decision-making by a group when characterized by uncritical acceptance or conformity to prevailing points of view”. Large institutions aren’t simply in the market to achieve positive returns for their stakeholders, but also for themselves. Large fund companies and brokerages have a vested interest in maintaining and significantly growing funds under management as a means of generating revenue through fees (MER’s) and commissioners or securing market share from competition. The zero-sum argument assumes that active management’s sole priority is simply to achieve excess returns, which we know is not the sole motivator. The benefit of active management to many is that a significant portion of investors have no desire in managing their own finances, so this places a single DIY investor outside the majority of the market in any investing environment.

One of the most significant benefits of a herd is that it creates safety in numbers. Segments within the group of institutions may form social circles of commonality or label themselves with specific titles such as value investors, growth investors or technical analysts, but the incentives for those involved in these institutions are clearly never the same as a singular DIY investor. Safety is the clear advantage of this group of investors and individuals working within the industry will find it difficult to lose their job during good times or bad since so many others appear to be doing the same quality and quantity of work. This behaviour was clearly evident recently within the sub-prime mortgage crisis in the US financial markets where companies of all varieties participated in activities that clearly went against sound financial decision making. One individual looked at what others were doing and group-think took over when members saw the potential returns that could be achieved without concern to the dangers within the market. The specific percentage of the market that participates in similar behaviours is tough to gauge by numbers (mainly because institutional investment statistics aren’t readily available) but a safe assumption could be that over 40% of market movements are responsible by this process. This is what I find difficult in assessing the alpha of any one or group of fund managers. If their focus or motivation is not completely on achieving excess returns and rather on driving revenues through fees and following the habits of others within the herd, then outperforming the market on a historical basis becomes somewhat cloudy as an evaluation tool.

Since more than half of market movements are conducted by this group majority, group-think behaviours can cause the market at times to swing away from fundamentals of investing. If this group moves as one, within a few standard deviations of each other, then intellectual capital should exist in some form to contrast the movements of the herd. If a DIY recognizes the frequent flaws within the market that traditionally occur time after time in creating bubbles of varying types, then value can be created by contrasting or not participating in such activities. A DIY investor could instead choose to focus on reducing a higher exposure to risk than those invested with the herd and thus decrease their exposure to systematic risk. Although you may not participate in the swings of the market herd, you can navigate amongst them to selectively pick out the value that you identify to exist where no one else is looking. Of course, a single investor may have no desire to quantify their returns against any benchmark or index strictly due to the difficulty in finding one that matches their investing technique. You can invest solely into the market, but as stated above, there are movements in the market that expose your investment to specific risks.

Investing also contrasts two independent talents of any investor whether institutional or DIY: skill vs. design. An individual investor (such as O’Shaughnessy, Chou, Buffett) or group of investors may have skill in a process of selecting a specific niche of securities they excel at, while others will find success at implementing a design of investing that offers extraordinary returns. Which one impacts or tests the value of intellectual capital is never easy to assess, but my own approach is the pursuit of the latter. Investment design can achieve an unlimited amount of intents from implementing a cost effective index, dividend growth or increasing cashflow strategy to hedging against inflation, currencies or contrasting any number of other techniques. A designed investment approach has the potential to expand on a traditional approach and focus a greater emphasis on outperforming the inherent dangers, traps, fundamental flaws and volatility that the majority of the market experiences.

My own value approach hinges on the general assumption and practice that although most of the markets behaviour reflects some amount of fundamentals, the majority is based upon emotion. Overreaction to good or bad news rarely occurs after investors sit down to assess fundamentals on paper on a moment’s notice, but more by speculation of what such news could indicate in a worst case scenario. Speculation and emotion often run hand in hand, while fundamentals (although boring) tend to reveal the true environment in which a company should be priced. Although I myself respect the teachings of Graham immensely, I’m not certain that any amount of “tremendous effort” is required to beat the market. In any market environment there exists emotional behaviour that goes against fundamental value of dollars and cents that can be recognized and exploited. Buffett himself can attest that some of his best investments came from the simplest of situations where he perceived value to be in a chaotic environment of emotion that didn’t focus on any amount of fundamental worth.

While any zero-sum assumption appears to gain merits as it accounts for equal gain and loss among investors, should we simply accept the average? If all we do is accept and expect the average return of the market, then what motivation or inspiration is there to improve? One could argue that intellectual capital is just that: the specific investors’ ability to differentiate themselves from the herd mentality of the market that results in a positive outcome.

Even the merits or assumptions of ETF’s don’t necessarily translate into the majority of investors utilizing this tool in order to gain a long-term cost advantage. They’ve become increasingly popular in recent years, but their function doesn’t follow the intended design or merits of the vehicle. The obvious benefits of an ETF strategy would be to hold for the long-term in an attempt to reduce cost, maximize gains and re-balance accordingly through DCA. But active management of an ETF strategy still includes excessive use of commissions on trades promoting another zero-sum situation where many investors trade an ETF on a frequent basis rather than quarterly or yearly rebalancing. Through the next down cycle in the market, what will be the attitudes and behaviours of these same investors? Will the group average down over a period of stagnant/declining growth in order to capitalize on average cost or flock to active management in the hopes of minimizing losses attributed to the proper use of the strategy? Will investors have the patience and commitment to utilize the ETF strategy to its full potential over the long-term?

I’ll admit that the easiest method of determining the value of intellectual capital would be by some measurable form, but there also needs to be a focus away from just numbers when attempting to gauge what amount of value is created by this competency. To utilize a pure quantitative analysis of broad stock indices requires skill, intellect, patience and often significant financial resources. Many viewers of BNN know Brian Acker as a regular guest on Market Call, yet he himself has admitted that his “black book” took over eight years to develop. Whether you agree or not with his approach, outlook or investing discipline, the fact stands that if indeed it took him nearly a decade to develop his model that there was some significant financial cost in doing so based solely on quantitative factors.

I am among the minority of investors who focus largely on qualitative factors. A company requires the ability to crunch the numbers to stay successful, but behind all the numbers are countless factors that are never easily measured that can be solely responsible for a corporation’s success. True value can be most easily defined as qualitative factors over looked by the majority of the market. My Value Rules themselves are comprised of almost 75% qualitative factors that historically have shown impressive opportunities for value creation both over the short-term and long-term periods. Intellectual Capital could also be defined as doing what everyone else doesn’t – as contrarian movements often generate value away from prevailing thoughts of the herd.. Herd mentality often drives thinking in one or two directions which may or may not be driven by basic fundamentals. Opportunities frequently arise from herd behaviour and many contrarians have enjoyed success by simply going against the grain

Even Modern Portfolio Theory (MPT) has a tragic flaw in my view: it argues that investors are rational in their behaviour, but we know this isn’t completely true. MPT suggests that if given the choice between two different securities, an investor will choose the one with less risk. Investors frequently take on more risk in an attempt to increase returns in the presence of information that places risk well beyond their individual threshold (especially in a bull market). The value of intellectual capital thus hinges between comparisons of the average investor (herd) and a properly risk-adjusted cost efficient strategy.

Cost management is only a singular component in assessing the value of intellectual capital as Scomac has suggested. I myself know through my own creation and application of my Value Rules that while many investors pursue excess returns, my own reflects a concentration of a margin of safety within an investment as a deterrent to risk and management of volatility of the portfolio. My belief is that cost control holds impressive opportunities for long-term investors, but that decreased volatility and appreciation of capital are directly correlated to one another. The analogy I often is that it’s impossible to tame a lion in the wild, but you can hope to manipulate its environment in an attempt to produce a desired behaviour. Increasing safety and implementing barriers forces a lion into limited choices & a better expected outcome. I don’t suggest that you assume you can control the market similar to this example, but by being protective of your investment and evaluating what you do your margin of safety increases to a much higher degree.

If you choose to shoot for the average and focus on controlling your cost by using the most efficient method available, then the returns against the herd are obvious and clear. But I am one who continuously challenges himself to improve, recognize, take advantage and streamline my investing discipline to achieve over time a return that is conducive to my own investing priorities and expected return. In any given quarter, year, market or cycle my capital may be better off with another manager, in another investment or simply deviating from my specialized strategy. But my belief is that over the long-term, the intellectual capital I’ve invested into my own strategies will pay off with significant value. I combine cost, qualitative factors and the study of market behaviour to sift through the emotional fluctuations of the market to see where a higher degree of value emerges.

Tracking, measuring or determining the specific returns that are added to an investor’s performance in a quantifiable way is only one measure of evaluation. I acknowledge that the difficulty is amplified when attempting to assess the qualitative methods that some investors (such as myself) utilize to create value in our pursuit of intellectual capital. The only evidence I can suggest at this time is that an investor keep an open mind, examine the market with a view of absent emotion and focus their investing activities on the reduction of risk rather than the pursuit of excess returns. If you view your returns as a slow and steady appreciation rather than wild and turbulent returns year to year, then the emotional component becomes much easier to swallow. Whether or not my strategy, arguments or knowledge of investing meets those of any other investor is irrelevant; as long as you yourself find what you do best, adjust your investing activities to meet your individual needs and always remember that no one has the same intentions for your money as you do.

All this being said…I still index my RSP as a hedge according to Scomac’s suggestions. The reasoning is that there is a possibility that my active DIY application in these three portfolios (Value, Dividend Growth & Healthcare) will turn out to generate returns that lag the general market over the long-term. But my pursuit of intellectual capital likely won’t change…chalk that up to being young and ambitious.

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