Why I Think One of America's Greatest Investors May Be Digging Through My Mail

Howard Marks, one of the wealthiest investors in the United States, just released his newest investor letter, and in it, I find a few ideas that are eerily similar to what you and I have been talking about for months: Index investing is a dangerous, expensive Wall Street con.

If you're not familiar with this battle-scarred (and unreasonably wealthy) veteran of the markets, Marks fought his way through both the equity and bond markets for over 40 years.

He also happens to be an extremely incisive writer, with his book, "The Most Important Thing," considered a must-read for anyone looking to achieve success as an independent investor.

In his latest letter, he takes on index investing, an approach that I frequently call a silly waste of time if you're beyond middle age and don't have four or five decades to build your wealth.

Ironically, it was Marks' University of Chicago professors who birthed the idea of index investing in the late 1960s. They saw it as a way to ensure you never underperform the Dow Jones Industrials or S&P 500, as well as never pay ridiculous management fees. (So much for that idea...)

But what most investors don't understand about indexes - and what I want to show you today - is that indexes didn't become popular because the returns are phenomenally good...

... rather, it's because the active managers have phenomenally good salesmen working for them night and day to sell the pipe dream of low-risk, high-return indexing to regular, unsuspecting investors...

In other words, the active managers are phenomenally bad...

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Buy the Indexes; Buy the Fund Manager a New Suit

Now, I'm not saying that these businessmen and women who storm the lower Manhattan streets five days a week are all awful people.

I'm saying that they sell you index-component firms like Apple Inc. (Nasdaq: AAPL) and Coca-Cola Co. (NYSE: KO) because it's their key to earning the outsized fees to support absurdly high salaries, even more absurdly high bonuses, and brand-new overpriced suits.

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Unfortunately, paying those people isn't how you make unreasonably good returns; it's how you end up with less than ho-hum index returns minus ridiculous fees.

That "performance," if you can call it that, is enough to put you in the negative, when you consider the S&P has returned just 3.7% a year over the last 20 years on average.

Career risk will take one or two percentage points off even that dismal total, as no sane broker will want to go against the pack and get fired for being wrong for unconventional reasons.

Don't get me wrong: On Wall Street, it's okay to be wrong for conventional reasons. Losing money always sucks, but owning the same stocks as everyone else and still losing money doesn't warrant too much public scorn.

But... losing money for trying something unconventional means explaining to the beautiful wife that the kids are now going to public school and the trip to the south of France will be moved to the south of New Jersey instead.

Doing what everyone else is doing means you end up with the returns everyone else is getting.

For most active managers, that means less than the already paltry long-term returns of the stock indexes.

If you look at the markets as a bell curve, most managers, active and passive alike, are in the middle of the curve. They're earning returns that are right around the median of the group.

The higher returns are out in the tails of the distributions. If we look at the data from Cambridge Associates, it becomes clear that one particular "breed" of investor earns the biggest returns.

This crowd has something of bad reputation, but then again, they've made multiples of the S&P 500's returns over the past 18 years.

This Crowd Has a Lock on Winning Profit Strategies

The smart money out there in the markets - some of the biggest, most successful investors, like Leon Black and Josh Harris at Apollo Global Management LLC (NYSE: APO), Robert Smith at Equity Capital, Stephen Schwarzman at Blackstone Group LP (NYSE: BX), and Henry Kravis and George Roberts at KKR & Co. LP (NYSE: KKR).

Now, the media portrays these guys as the bloody-fanged wolves of the U.S. economy, and they do a great deal of the "creative destruction" necessary to churn capital and lend momentum to the economy.

Rather than wolves, I see them as extremely talented at generating big returns. That's why I believe their methods are worth a much closer look.

I'm talking about leveraged buyouts. The buyers look for unreasonably good companies to own - to "buy out" - and use a mix of equity and debt to make the purchase. The company's cash flow is used to secure and repay whatever was borrowed to make the buy.

And since debt has a lower cost of capital than equity (interest payments reduce tax liability, after all), bigger gains pile up over time, such that the debt is used to "juice" returns on equity.

Genius!

The trick, if you're in leveraged buyouts, is finding what companies you want to buy.

Naturally, my head has spent hundreds of hours buried deep in academic research, crunching numbers and reviewing successful leveraged buyouts that returned many multiples of the original amount invested.

With a lot of help from friends and standing on the shoulders of many intellectual giants, I boil down what the smart money does and distill it into a formula that works very well in the public equity markets. I've become pretty good at replicating the process, if I do say so myself - and I do say so myself.

And I'm admittedly a little bit greedy, so I'm going after even bigger returns: Venture capital--style gains.

However, I knew it would be difficult for a guy who still questions the designated-hitter rule and has a "just because we can doesn't mean we should" view of technology to understand and replicate those VC returns.

Luckily, my daughter married a guy with several finance and economics degrees who has a real knack for understanding the demographic, technological, and geopolitical trends that will shape our future.

My son-in-law and I frequently talk about breaking down venture capital into an approach that regular folks can use to invest in the other fat tail of the market bell curve. Many bottles of wine and steaks went to the great beyond in the process, but over time, we've developed a VC model that can deliver VC-like windfalls for everyday folks looking to increase their wealth.

I can't wait to share our findings with everyone. You'll be the first to hear about them - because these are the kinds of strategies you need to use if you simply don't want to wait decades to make a fortune in the markets.

As Mr. Marks reminds us in his letter, passive-index investing is more of a "can't-whine" approach than a "can't-lose" approach. It's a fine strategy if you want returns as meager as 3.7% (or less) a year.

I am more like Earl Weaver in that I don't just want to win - I want to win big.

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About the Author

Tim Melvin is an unlikely investment expert by any measure. Raised in the "projects" of Baltimore by a single mother, he never attended college and started out as a door-to-door vacuum salesman. But he knew the real money was in the stock market, so he set sights on investing - and by sheer force of determination, he eventually became a financial advisor to millionaires. Today, after 30 years of managing money for some of the wealthiest people in the world, he draws on his experience to help investors find "unreasonably good" bargain stocks, multiply profits, and build their nest eggs. Tim tirelessly works to find overlooked "hidden gems" in the stock market, drawing on the research of legendary investors like Benjamin Graham, Walter Schloss, and Marty Whitman. He has written and lectured extensively on the markets, with work appearing on Benzinga, Real Money, Daily Speculations, and more. He has published several books in the "Little Book of" Investment Series and a "Junior Chamber Course" geared towards young adults that teaches Graham's principles and techniques to a new generation of investors. Today, he serves as the Special Situations Strategist at Money Morning and the editor of Peak Yield Investor.

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