Should you be trying to pick stocks?

By Felix Salmon
May 12, 2010
Tadas Viskantas reckons that we might be entering a "golden age of stock picking". Why?

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Tadas Viskanta reckons that we might be entering a “golden age of stock picking”. Why?

This volatility seems all the more meddlesome in light of the growing belief that the equity risk premium is likely to be lower in the future than it has been in the past. Whether you attribute this to risk-seeking behavior on the part of individuals or simply an artifact of history, in either case it makes the potential rewards of the stock market seem not worth the risk to many.

One could argue that we have already seen a retreat by investors from picking individual stocks into collective, diversified vehicles like mutual funds and exchange-traded funds. Furthermore post-Internet bubble it seems that speculative activity on the part of individuals has been funneled into trading ETFs and more recently foreign exchange. Individual stocks seem to be the artifact of a long gone era of investing.

Therein lies the opportunity. With everyone focused on the global macroeconomic situation it seems as if good old fashioned stock picking is being forgotten. Rather than fixating on the downside of volatility maybe investors should be focused on the opportunities created by said volatility.

Who wouldn’t have wanted to buy Accenture or Procter & Gamble at $0.01 on Thursday? These are clear anomalies but the broader point still stands. If the market is going to go through periodic episodes of volatility that bring down the prices of all stocks (good and bad) doesn’t it behoove investors to take advantage of these opportunities?

I’m not convinced, and not only because active investors, in aggregate, never outperform the stock market.

Firstly, volatility is good for traders, not investors: just check out the spectacular trading results at the money-center banks last quarter. Those profits come from trading desks which are structurally flat(ish), rather than from investors who are structurally long. The advantage that investors have over traders is that they have time and patience, but if stocks in general are going nowhere over the long term, then that advantage dissipates, and playing the stock market becomes a zero-sum game in which the big banks are winning and therefore everybody else is losing.

More generally, there’s no real evidence that I know of which suggests that stock pickers in general, and value investors in particular, outperform during periods of volatility. To the contrary, my feeling is that they do best when stocks in general are cheap and rising, in the earlier stages of bull markets. It’s true that a small subgroup of opportunistic value investors — Bill Ackman comes to mind — has a real ability to identify securities which have overshot in periods of volatility and are therefore mispriced. But as Ackman’s own Target trade proves, this is a high-risk strategy which shouldn’t be entered into by anybody who can’t afford to lose the money they’re betting.

Conceptually, I think that what Tadas is talking about here is a strategy of sitting patiently at the side of a turbulent river, and waiting until a juicy fish just jumps out and lands in your lap. But it’s not as easy as that. Buying low is also known as the catch-a-falling-knife trade, which has left many a smart investor extremely bloodied. And once a stock has fallen far and you’ve missed the opportunity to buy it at its lows, it can be psychologically pretty hard to buy it at significantly higher levels.

Most importantly, however, in a choppy sideways market, investors have to be able to sell high as well as buy low. Which basically means that they have to have trading skills on top of those analysis and investment skills. It’s a rare combination.

Finally, I think it’s pretty clear that we’re now living in a highly interconnected world where confining yourself to a single asset class, like U.S. equities, is placing yourself at a massive disadvantage. And individual investors don’t remotely have the resources to be able to position themselves strategically across the incredibly diverse range of instruments which are now available globally.

There are surely opportunities out there, but I doubt that the best ones involve the old-fashioned method of paying cash dollars for U.S. stocks; in fact, my guess is that the big value-investor returns will come from buying elsewhere in the capital structure, and especially from restructuring trades where debt turns into equity with real long-term value. And for those, you need to be not only a good analyst and a good trader, but also a qualified institutional buyer and have access to excellent lawyers. And your minimum investment, especially in the loan market, is going to be enormous.

Tadas says that “the rise of the self-directed 401(k), the emergence of discount brokers and the proliferation of news/data sources via the Internet all played a role in making investing both cheaper and simpler.” That’s true. But it’s a narrow slice of the global investing universe. And it’s not necessarily the most attractive one right now.


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“the rise of the self-directed 401(k), the emergence of discount brokers and the proliferation of news/data sources via the Internet all played a role in making investing both cheaper and simpler.”

Also, Flash and embedded multimedia notwithstanding, the discount brokers’ websites are still less garish than Vegas.

Posted by dWj | Report as abusive

The following paper looks at the stock-picking skills of a fairly large group of “value-investing” hedge funds during the tumultuous markets of 2000-2008 — it might be of interest to you and/or your readers: bstract_id=1477586

Posted by callesantiago | Report as abusive

There are a lot of consistently successful value investors. Motley Fool CAPS for instance is full of them.

Your logic could be applied to running marathons for instance. You could say, people generally can’t run marathons. That would be true in a first approximation, since perhaps less than one percent of people can successfully run a marathon without stopping. Yet hundreds of thousands of people or perhaps more than a million can do it.

Further, you talk as if investing is a zero sum game. Every person’s wins are someone else’s losses. Nothing could be further from the truth. The history of capitalism teaches us that money invested well earns its own return and creates its own wealth. You aren’t stealing away someone else’s returns but generating new wealth that would not have existed without those investments (assuming you find something with a good return). The economic pie has continued to grow for centuries on the carefully selected long-term investments, both public and private, of millions of people.

Index investing is great for most people because you are piggybacking on the aggregate decisions of a lot of smart people. But it is absolutely crucial for markets that lots of smart people ignore the indices and strike out on their own so that all the followers have something to follow.

If you can analyze companies and find value, as many people can every day, rock on! You are generating wealth not only for yourself but you are leading all the index investors who are automatically piggybacking on active investors.

Posted by DanHess | Report as abusive

“Most importantly, however, in a choppy sideways market, investors have to be able to sell high as well as buy low.”

Actually, it probably means that stock pickers will put more weight on dividends than they did in a rising market. This is actually very healthy for the market, since it is likely to force firms to make real profits that can be paid out to owners.

Posted by csissoko | Report as abusive

I think this is a typical ‘this time it’s different’ post. It’s in times of groupthink such as this that the smart and patient can achieve things that the busy and restless can’t.

Posted by edcroft | Report as abusive

Why not try? Find stocks that got hurt in the crash last week and jump in

Posted by STORYBURNcom2 | Report as abusive

I question, “…if stocks in general are going nowhere over the long term”

While that is true over the past decade, it has primarily been the result of P/E retraction. JNJ first hit its current level back in 2002, yet earnings have more than doubled since then. If that were to happen again over the NEXT decade, we would be looking at a P/E of 5-6. Bets on that?

Posted by TFF | Report as abusive

Stock investing may be cheaper, it is not simpler. I agree that you can, with much work, beat the market periodically, and volatility can help, but I also think there are not that many good bargains right now, even given the dip. Nov08-Mar09 – different story; it takes a perception that the world is going to come to an end to create the margin of safety that postpones, not avoids, regression to the mean. After that, it *just* takes a lot of very careful and time consuming analysis.

Posted by ARJTurgot | Report as abusive

“All these pitfalls notwithstanding, the individual investor who manages to make, say 15 percent over ten years when the market average is 10 percent has done himself a considerable favor. If he started with $10,000, a 15 percent return will bring a $40,455 result, and a 10 percent return only $25,937.” –Peter Lynch

Posted by mtracy9 | Report as abusive

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