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Farr: Bill Gross, Rating Agencies, and Mob Mentality

Faithful readers of my weekly market commentary know that I value the opinion of PIMCO bond manager Bill Gross. Gross has compiled a terrific record as a fixed-income manager, and he regularly proves to be ahead of the curve on issues affecting the global economy.

Gross's monthly Investment Outlook, posted on the PIMCO web site, is both informative and entertaining, and I recommend it to everyone. This month's piece is especially entertaining as it takes the rating agencies to task for missing the boat on so many disasters over the past several years, including Enron, Worldcom, sub-prime mortgages, and sovereign debt. I discuss his commentary below while adding my own.

Gross's condemnation of the rating agencies begins with a description of the necessary components for successful investing. Investors, Gross says, need both smarts as well as common sense to succeed. The ratings agencies are sorely lacking in the latter, and this deficiency caused them to repeatedly fail to identify ticking time bombs.

Rejecting the Efficient Markets Hypothesis, Gross says that securities prices are:

"a delicate combination of mathematical value and human nature - something that quantitative scholars and practitioners rejected to their eventual ruin in their pursuit of "efficient" markets. And human nature, it seems, cannot be so easily modeled nor intelligently divined. It feeds on itself quite frequently, leading to accentuated periods of "greed" and "fear" that tend to be labeled "bubbles" or "black swans", respectively. It is during those periods that a tablespoon of common sense is just the recipe for investment success."

Gross goes on to say:

"The result [of the rating agencies lack of common sense] has been the foisting of AAA ratings on an unsuspecting (and ignorant) investment public who bought the rating service Kool-Aid that housing prices could never really go down or that countries don't go bankrupt. Their quantitative models appear to have a Mensa-like IQ of at least 160, but their common sense rating was closer to 60, resembling an idiot savant with a full command of the mathematics, but no idea of how to apply them."

We at Farr, Miller & Washington have written about this topic many times before. We have consistently warned our readers that blindly following the herd can result in devastating consequences to one's portfolio.

What Gross calls "common sense", we refer to as our "investment discipline". Our strict investment discipline, or our process for identifying attractive investments, relies upon a combination of fundamental analysis and valuation analysis. We adhere to rigorous quantative and qualitative criteria with regard to balance sheet strength, historical performance, returns on capital, earnings growth, management prowess, and valuation. This screening process is designed to take emotion out of the investment decision. It is designed to keep us from chasing the herd. It led us to sell most of our financials in 2007, and it kept us from chasing commodity stocks in 2008.

Conversely, our discipline allows us to take advantage of attractive prices when fear is rampant.

Bill Gross's "common sense" and our "investment discipline" seem so simple and basically boil down to the old investment axiom "buy low and sell high." However, as anyone who has been investing for more than 10 years knows, it can become incredibly difficult at times to maintain one's discipline in the face of overwhelming market forces. The proliferation of hedge funds, the widespread availability of data and news on the internet, and the popularity of financial news networks all mean that the average investor has become much more short-term oriented. From our perspective, this clear trend creates an opportunity for those of us (with common sense) that still invest money with a view for the long term.

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Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.