In trying to understand the concept of active management, and its potential for success, let’s begin with the question: What is a stock?

A stock is simply an ownership share in a company. Each share of stock in a company represents a part ownership for the shareholder. And each share of stock represents a claim on a share of the future profits of the company.

Given that the future is uncertain, the future profits of a company must also be uncertain. It’s reasonable to assume that we can be more certain about a company’s profits next year, than about those ten or twenty years from now. And the further out into the future we look, the less certain those profits are.

Next question: What does a stock’s price represent?

A stock’s price represents the value of all of the company’s expected future profits, discounted back to today, divided by the number of shares that have been issued. We discount the expected future profits by an interest rate so that we can express their value in current dollars. The higher that interest rate – or “discount rate” – the less certain we are about the future.

Now for most stocks there are literally thousands of investment analysts, fund managers and other professional investors evaluating those expected future profits, and discounting them at what they consider to be an appropriate interest rate. They’re arriving at their own idea of a “fair value” for each stock, and then buying or selling accordingly.

So, let’s consider a widely-traded stock like Coca-Cola. Today’s price for a share of Coca-Cola is, say, $41. Well, that price represents the consensus – or average view – of all those thousands of investors about the expected future profits of Coca-Cola.

What might cause the price of the stock to move? Well, new, unknown information – which could reflect good news, like higher profits for the next quarter, or bad news, like lower sales, lower market share, and so on.

So, we know what a stock represents – part ownership in a company, and a right to a share of its future profits. And we know what the stock price reflects – the value of all those future profits, expressed in today’s dollars.

So let’s now turn to the underlying premise of active management. Active management presumes that an investor can consistently identify securities that are mis-priced, and buy or sell them at a profit when the price moves to its correct level, thereby generating returns that are better than the market or a particular benchmark.

In reality, what needs to happen for active management to work?

For simplicity’s sake, let’s consider only active managers who look for under-valued stocks. First, the investor must find a stock that all the other thousands of professional and amateur analysts and investors have under-valued. Then, as some point after the investor has bought this under-priced stock, all the other analysts and investors must recognize the mis-pricing as well, and start buying more of the stock to push its price up to the correct value. Quite a stretch of the imagination, to say the least.

At Springwater, we don’t believe that any investor, analyst or fund manager can consistently identify mis-priced securities, because we believe that securities prices reflect all known information. And since it’s new information that changes expectations about future profits – and new information is by definition unknown – trying to predict future price movements is in reality nothing more than educated guesswork, or speculation.