Can You Beat The Market?

Can You Beat the Market?

Executive Summary:



 

Got Alpha?

 

Beating the market is no easy task. Every investor out there is trying to achieve the same goal you are – generating alpha. Alpha is the excess return relative to a benchmark index. So if you generate a 15% return and the S&P 500 generated a 10% return, your alpha would be 5%. With alpha generation at an all time low and inflated management fees everywhere, money has been moving away from individual stock pickers at mutual funds and hedge funds to low cost ETFs. Given recent fund performances, I think it’s fair to say that stock picking doesn’t look so hot nowadays. So the question is, can individual stock pickers generate alpha consistently over time and beat the market as opposed to ETFs?

 

The idea for this topic came from my article on Portfolio Management where I received a question from a reader on what are the pros and cons of picking individual stocks as opposed to investing in ETFs. Its a valid question, especially at a time when hedge funds and mutual funds are bleeding assets while ETFs continue to see capital inflows. My goal for this article is to tackle the question of whether individual stock pickers can generate alpha over time, the pros/cons to stock picking versus ETFs, and finally what I would recommend to the average Joe out there.

 

Being Different

 

Just to be clear, I’m a stock picker. However, even I’m willing to admit that going through a 10K, analyzing financial statements and updating financial models day after day to make just a handful of investments throughout the year is a grind. So is it really worth it? Well, to answer this question we need to look at investing holistically to understand why we would go through all the torture of picking individual stocks in the first place. Let’s start off with performance. Individual stock pickers like myself, similar to hedge funds, are aiming for absolute returns. An absolute return means that I want to generate positive returns every year, irrespective of what the market does. This is the main difference between mutual funds and hedge funds. Mutual funds rely on relative performance, which is how well they perform versus their benchmark, like the S&P 500. So let’s say the stock market drops down to negative 10% for the year. If the mutual fund drops only 8%, that goes down into the books as a win (which I think is weird). Regardless of how much the markets drop, my goal is to win all the time and generate positive returns. The problem is that you can’t win all the time if you hold an index fund, or if you buy enough stocks to mimic an index (these are called closet indexers). To beat the average, you have to be different!

 

The same, but different meme

 

Although the mutual fund category as a whole can be considered stock pickers, most are structured in such a way that they are basically ETFs with higher overhead costs. The main problem is the institutional culture prevalent at the mutual fund companies. If the stock market is up 10%, you don’t want to walk into your boss’s office and be the guy that’s down 10%. At the end of the day these mutual fund managers are just well paid employees, and they don’t want to get fired just as much as anyone else. This mentality forces managers to buy a broad range of stocks so that their performance doesn’t deviate too far from an index. These managers are referred to as closet indexers and they shouldn’t be included with the true stock picking crowd.

 

The chart below is a study provided by Lazard Asset Management, which shows the alpha that has been achieved across different investor types.

 

Lazard Asset management excess returns chart for individual stock pickers

 

After separating out the closet indexers, stock pickers are the clear winner.


 

Long-Term Alpha

 

To better understand what drives performance for stock pickers we need to understand how the market impacts the opportunity set for active stock picking.

 

When interest rates fall, asset prices rise since its cheaper to access capital. That’s why although mortgage rates are pretty low right now, home prices are shooting through the roof since more people can borrow money and compete for houses. The downside to increasing prices is that the expected return you can achieve from buying an asset decreases. This is when indexing wins out. A rising tide lifts all boats and as a stock picker its hard to justify your value in generating excess returns when everything else is rising. A novice with no investment experience can generate the same returns with an ETF in this environment.

 

Shown in the chart below, when interest rates fall that’s when stock pickers tend to struggle. Conversely, when interest rates rise, stock pickers tend to outperform.

 

U.S. Active Fund Excess Return vs. Rate Environment

 

During a rising interest rate environment, the cheap money goes away and asset prices fall. During this market dislocation, that’s when stock pickers show up in force and start buying companies on the cheap, which lays the groundwork for excess returns down the road.

 

Here’s an interesting chart provided by Equitas Capital Advisors on the cyclicality associated with active versus passive investing.

 

Active and Passive Investing is Cyclical Chart

 

As you can see, the current period we’re in isn’t the only time active investing has sputtered. Also notice that active investing has rebounded every time. I believe active stock picking still provides the opportunity to generate alpha if you look past short term market cycles. Value investors that I follow have been able to withstand these cyclical swings since they are focused on financially sound companies trading at low valuations and they utilize a long-term investment horizon. This is basically a private equity approach that’s being applied to the public markets. I don’t think its a coincidence that private equity firms like Blackstone produce investment returns similar to value investors like Warren Buffet over the course of 20+ years (~25% per annum). It comes down to discipline, an understanding of valuation, and an understanding of quality companies that possess an economic moat/competitive advantage.

 

Stock Picking Versus ETFs

 

As mentioned earlier, investing in stocks takes a lot of work if you want to do it right. Even then it can be frustrating. Like most value investors I measure my success over the long-term, which to me is 15+ years. Unlike day trading, there is no instant gratification for buying a large cap stock and waiting for it to grow and pay dividends. Its basically like watching paint dry. Picking stocks is not a get rich quick scheme like most people hope for, but I believe that you can still grow your wealth meaningfully over time if you maintain a disciplined approach. Here are my reasons on why you should be a stock picker.

 

Stock Picking

 

Pros

  • You can beat the market and generate alpha
  • Full control over prices and valuations at which you are willing to buy
  • Solid understanding of the companies that you own
  • Mitigate risk (through valuation and company analysis)
  • Full control of your portfolio and its composition
  • You determine the holding period and when you want to sell
  • No management fees

 

Unfortunately its not all sunshine and roses so here’s the downsides to being a stock picker.

 

Cons

  • Excessive amount of time reading, studying, and analyzing
  • An opportunity to outperform the market can also lead to underperforming it
  • Bad decisions can have a large impact
  • Emotions (If a stock falls 20%, are you still a believer or do you sell?)

 

In general I would only recommend stock picking for individuals that have an understanding of corporate finance and are willing to put in the time and effort to analyze a stock thoroughly. Stock picking is not for beginners. To stand a chance you really need to know what you are doing and have a passion for understanding the underlying mechanics of a company. When you buy a stock you’re not just buying piece of paper (or a digital one nowadays), you are buying a piece of a real business.

 

In an environment where all stocks are steadily rising due to central banks injecting massive amounts of liquidity into the markets, I think ETFs are the way to go. If active managers are charging exorbitant fees while all stocks are similarly rising, just cut out the middle man. ETFs were created to make investing easier and cheaper for the average person and I think its a great solution for most people. Here’s my take on why you should invest in ETFs.

 

ETF Investing

 

Pros

  • Cost effective
  • Good for beginners
  • Guaranteed to perform in-line with the market
  • Hardly any time commitment
  • Investing can be easily automated and a program can be set-up for dollar cost averaging
  • One bad stock will have a limited impact on performance

 

As you can see, ETF investing offers great benefits for the majority of investors out there. That’s why they were created in the first place. Unfortunately, ETFs aren’t perfect and I mention their main flaws in Rising Risks of ETFs. Here’s my list of downsides you should keep in mind while investing in this type of product.

 

Cons

  • Guaranteed to not beat the market
  • Fees (some cost more than mutual funds!)
  • ETFs own every kind of stock, including the bad ones
  • Harder to manage risk
  • Exposed to buying overpriced stocks

 

An ETF is meant to mimic an index, which means by definition you are guaranteed to not beat that index. Another issue is that ETFs are not focused on company fundamentals or valuation. This can become a big problem when market values rise to all time highs since an ETF will just keep buying more of an overpriced stock.

 

Final Thoughts

 

I’ve always found investing to be an enjoyable and challenging endeavor. The stock market is like a giant chess board where you have to strategically position yourself for the next move and constantly out-think your competition. This dynamic drives my thirst for knowledge on understanding the financial markets and learning the inner workings of companies, which naturally lead me to become a stock picker. Overall, I think it is a rewarding experience not only financially but also intellectually.

 

I will honestly say that stock picking is not for everyone, however. For the average Joe I would highly recommend staying far away from stock picking unless you have the understanding and the desire to invest in individual companies. ETFs were created to fill this void and make investing easier, which I actually think is a great thing. I believe an ETF can be a good product during a normal market environment if valuations are at reasonable levels. However, given the current environment where central banks have intervened so heavily in the markets and there is now talk of tapering, extreme caution is warranted.

 

My personal recommendation for the average investor out there would actually be to invest in a reasonably priced mutual fund with a focus on fundamental value. Check out TRMCX as an example – .80% expense ratio and 50% turnover, which I think is reasonable. Over the course of 15 years the fund has achieved an 11.49% return annualized versus the S&P 500’s 9.34%. This particular fund might be closed-off to new investors, but I think a fund like this would be a much more prudent approach to investing than blindly buying ETFs.

 

So that’s my take on the benefits of investing in stocks versus ETFs. Let me know what you think and feel free to leave a comment below!