Before even considering which stocks to pick, investors should ensure that they have spent sufficient time and effort arriving at sensible asset allocations for their portfolios. Academic research has shown that more than 90% of returns from diversified portfolios can be attributed to asset allocation. In the article “Asset Allocation for Family Offices,” I argued that the best option for most family offices is to construct an “all-season” portfolio—in other words, a portfolio that is sufficiently robust and that can avoid large losses, regardless of what happens in the economy or on the financial markets.
Before moving into stock picking, investors should carefully consider whether to take an active or passive approach to equity investment. In his insightful article “Our Approach to Active vs. Passive Investing,” Per Lorange laid out the benefits and trade-offs of these two approaches. Even though certain investors may decide to follow the active stock-picking strategy, passive indexing should always remain the default strategy; in other words, investors should periodically compare their results against a passive index.
As Lorange indicates, most active stock pickers underperform in the market after accounting for their costs. This is not a surprise, as stock picking is essentially a zero-sum game before costs are factored in. If an investor decides to buy—and to thus overweight a certain stock—another investor will then sell to underweight the same stock. Only one of the two investors can be right, however. If the stock outperforms the market, overweighting wins—and vice versa. Because trading and active management generate costs and fees, active managers’ aggregate results must be worse (on average) than those of the market index.
When using active stock picking, therefore, it is important to first consider what can be learned from the passive indexing approach. As mentioned above, a key strength of the passive approach is its low costs and fees. Even active stock pickers should minimize their trading to keep costs as low as possible. Star investor Warren Buffett said, “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.” He also said that his “favorite holding period is forever.” Many of the world’s best stock pickers have annual turnover of less than 10% of their portfolios; thus, they hold each stock for more than 10 years on average.
Another important lesson from the success of the passive index is that investors should buy and hold onto stocks that are big winners. Most investors know that, over the long haul, stock markets in aggregate generate higher returns than cash or bonds. However, they may not know whether this also holds for the average individual stock. Professor Hendrik Bessembinder at Arizona State University analyzed all 26,000 publicly listed stocks in the United States since 1926 and came to a surprising conclusion: Less than half of the listed stocks generated profit for their shareholders over the stocks’ lifetimes, even including dividends. Professor Bessembinder found that the entire positive return of the stock market since 1926 came from less than 4% of the 26,000 stocks; the other 96% combined to have a zero return on average. A broad stock market index, such as the S&P 500, is unlikely to miss out on any of the big winners, but an active stock picker can easily do so.
Thus, the first active stock-picking strategy to consider is what I call “index minus.” Instead of trying to pick the winners, an investor following this strategy starts with the index and then tries to eliminate the losers. An analysis by GMO (a US institutional asset manager) shows that, since 1925, three sectors have underperformed in the market: the financial, materials and industrial sectors. Companies in the financial sector (e.g., banks) typically only have about 5% hard equity on their balance sheets. In other words, for every $1 of equity, they have about $20 of debt. If such a bank loses 5% of its assets, then its equity owners are basically wiped out. That is why banks seem to be in the middle of every crisis. Bank stocks also tend to lose more than the market average in a bear market or financial crisis. This excess downside volatility is exactly what investors should attempt to avoid. Therefore, eliminating most financial stocks from a portfolio is an easy decision. The materials sector includes many highly capital-intensive companies that earn low returns on their capital. Such companies sell commodities and thus have no pricing power. These factors also often lead to poor shareholder returns over the long term. Capital-intensive companies typically also have a lot of debt, which increases risks in down cycles. In summary, starting with an index and eliminating stocks that are likely to result in long-term losses due to excessive leverage (e.g., banks) or low returns on invested capital (e.g., materials firms and some industrial firms) is likely to produce a very satisfactory result.
Another active stock-picking strategy is “value investing.” Benjamin Graham of Columbia Business School invented this strategy in the late 1920s. The value-investing strategy involves buying securities that appear to be underpriced according to some form of fundamental analysis. The early value opportunities that Graham identified included stocks that were trading at discounts relative to their book values, such as those with high dividend yields or low price-to-earnings ratios. Value investors typically buy stocks that have performed poorly due to temporary problems that (the investors believe) have not permanently damaged the business, such that it has recovery potential. If these businesses turn around as expected, value investing can be very rewarding. However, there is always the risk of ending up in “value traps”—when the companies’ problems get worse instead of better and their stock prices never recover. Value investing has not worked well for the last 10 years, which may be because the current fast pace of technological disruption and obsolescence is causing an increasing number of value traps. Going forward, there is also a high risk of “stranded assets”—fossil-fuel reservoirs that can never be tapped due to limits on the amount of CO2 that can be released into the atmosphere.
Phil Fisher popularized the final strategy, “growth investing,” in his classic 1958 book _Common Stocks and Uncommon Profits_. Growth investors focus on identifying, buying, and holding stocks that produce big gains, even if those stocks’ share prices appear to be high in terms of price-to-earnings ratios. An excellent recent example of a successful growth stock is Amazon. Its stock price has almost always appeared to be very high relative to its price-to-earnings ratio, but the stock has still been a big winner. The downside of growth investing is that it can lead to paying a high price for a stock that ends up not being a big long-term winner.
It is important for investors to select the stock-picking strategies that suit their personalities and temperaments, as strategies are usually only effective when they are implemented consistently. The strategies listed above can also be combined. For example, Buffett started out as a Graham-style value investor but has, over time, become more of a long-term “growth at a reasonable price” investor (“GARP”). This strategy means finding high-quality stocks that can deliver above-average growth but that are not too expensive. Buffett now believes that “it is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
I also try to combine the three above-mentioned stock-picking approaches. My first goal is to avoid stocks that could produce big losses, including those for companies with weak balance sheets or low returns on invested capital—even if they appear to be cheap according to the principles of value investing. I then focus on identifying stocks that could be long-term winners and buy them when they are reasonably priced. Excellent buying opportunities appear, for instance, when an outstanding company experiences a temporary problem that is solvable over the medium term. Once I have managed to build a position in an excellent long-term growth company, my favorite holding period (like Buffett’s) is forever; in other words, I only sell if the business materially and permanently deteriorates or if the stock becomes excessively expensive.
Dr. Magne Orgland
Teufen, September 23, 2018
**Discussion questions for the Lorange Network community**
1. Can you name 1-3 attractively priced stocks (either value, “GARP” or momentum stocks) in either Switzerland, Germany, the Nordics, or the US?
2. Are there other stock-picking strategies you have identified that could beat the market?
3. What is your view on stock-picking vs. index-based investing? Do you find markets to be largely efficient or do you lean more toward the camp of behavioral finance?
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