Active Investing is Better Than Passive Investing In Overvalued Markets


Regularly readers of my blog will know that I recently moved some money out of a bunch of index funds and into my more actively managed portfolio. I can already here huge ‘sighs’ from the efficient market hypothesis faithful. Investors who religiously believe in index investing will tell you that it is impossible to beat an index fund over a considerable period of time. Whilst I agree with this statement, I also think that you need to use your brain at times and shouldn’t blindly follow any research. You need to be able to critically analyse the results of the research to see in what market environments the thesis or results holds true. I really do believe that people throwing money into index funds today will probably get lower returns than those who are buying individual stocks due to elevated levels of the markets seen today.

Take the S&P500 for instance. It is trading at a P/E close to 26. That is a near guaranteed formula for average low to mid single digit returns.A serial compounder like Nike on the other hand is trading at a P/E of 22. In any rational world, this should not be happening. If you have a look at Nike earnings quality and growth prospects against that of the general market, Nike is far superior. Someone investing in Nike today is bound to have greater returns 5 to 10 years down the line than someone investing in an S&P 500 index fund.

Before I go any further, I just want to state that I do not oppose index fund investing. Index funds are great if you want to build wealth without putting in any effort. By investing in an index fund, one piggy backs on the trend of ever increasing economic prosperity to generate returns and build wealth. You rely on a wide range of industries and sectors instead of focussing on specific companies.You still get the benefit of being able to take part in the greatest wealth generating mechanism in human history.

There’s no such thing as “passive investing.” As Ben Graham defined it in his magnum opus, Security Analysis, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” Because passive strategies entail zero analysis of either of these qualifications they are, by definition, speculative. And those adopting them are speculators, not investors.

Why I prefer Individual Stock Picking Over Index Funds

For people not interested in doing research or can’t tell a balance sheet from a profit and loss account, buying individual stocks is not worth the risk. In this case, by buying into an index fund, you can still benefit from the wonderful wealth generating ability of the stock market. I on the other hand enjoy enjoy doing the research, reading accounts and analysing businesses and that is why individual stock picking is more appropriate for people like me.

Here are some other reasons why individuals stock picking is better than the more passive index investing counterpart:



Index funds don’t provide diversification

Yes, you read that right! Contrary to popular belief, index funds don’t offer much diversification.
Take the FTSE 100 for instance, the top 10 holdings make up 48.78% of the index. This means that the 90 other companies in this index make up only 51.22%, which is less than 0.57% each. And when it comes to dividends, the FTSE 100 is even worse. 7 companies pay 79.8% of the total FTSE100 dividend. Shell and BP alone pay 15.3% and 7.6% each.

So on the face of it, you might think that a FTSE 100 index is great as you are buying into 100 different companies and that one or two companies performing bad will not affect your portfolio. But if those companies happen to be Shell, BP, HSBC or any of the major companies that have high weighting on the index, the whole index will be dragged down even if the majority of companies share price goes up. How’s that for diversification.

Just in case you are wondering, other index funds are just as bad. The S&P500 for instance also has a high weighting for the top 10 companies. The Top 10 S&P 500 company shave a weighting of 18.15% between them. This means that the other 490 companies only constitute 81.5% of the index.

Overvaluation

In highly inflated markets like we have across the developed world today, I believe stock picking and finding value becomes more important. The FTSE 100 and the S&P 500 are currently trading at very high multiples as compared to historical standards and this is due to certain stocks being expensive as opposed to all stocks within the index. This again has to do with the high weighting given to some stocks as mentioned above.

If you want better returns going forward, sticking to individual value stocks is a great idea.

It is important to remember that an index like the FTSE 100 is just a collection of companies. If you buy into a FTSE100 index fund today, you are buying Shell at £24, BP at £5.10, HSBC at £6.70, GSK at £15.64, Barclays at £2.35, BHP Billiton at £13, International Airlines Group at £4.50. Apart from GSK, the rest of these companies have high valuations and a rational investors would not buy these stocks at these prices. So why would you want to buy them under the blanket of an index fund?

Situational Knowledge

By buying index funds, you can’t take advantage of situational knowledge as you are buying into the whole market. A pharmacist can’t exploit the fact that a certain company’s drugs are increasing in sales rapidly in real time. I for example used my situational knowledge on Zambeef to purchase the company’s shares and I am now sitting on a gain of over 100%!. Even with the stock price increase, I still believe it is undervalued.



Frontrunning

Index funds by their nature have to buy companies that reach a certain market capitalisation (size). So the FTSE 100 for instance includes the biggest 100 UK listed companies. So when a company gets into the top 100, the FTSE100 indices buy into that company. This is great for traders or frontrunners as they can exploit this. Frontrunners buy and push up the price of certain stock so that index funds (and in turn you) are thus forced to buy the stock at elevated levels. Thus the frontrunner win as they can get a huge capital gain and you as an index investor lose as you buy stocks for much more than their intrinsic value. Have a look at my Woodford Patient Capital Trust post to see how I used front-running to my advantage and how index investors lost.

From the above, it can be seen that indexes can overpay for stocks. But they are also prone to selling at the wrong time. As index funds weighted by market capitalisation have to sell companies when their market cap reaches a certain threshold, they usually sell when a business faces the most pessimism and the stock is close to rock bottom. When thinking about index funds buy and sell decisions, it is easy to see why indexing is a momentum strategy prone to buying high and selling low.

Index investing is active investing in disguise

This will ruffle a few feathers but not all index funds are created equal. There is a committee which in facts decides which companies to include in a particular index.Apart from the big market weighted indices like the FTSE100 and the S&P500, index providers are free to chose which stocks to include in their index fund. Do some research and have a look at the mistakes the Dow Jones selection committee made when it removed IBM from the Dow Jones Index.

Being truly passive can leave you with lacklustre results. You need to look at indexes and see what their underlying holdings are. Just look at Small value ETFs from Vanguard (VBR) and Ishares (IWAW) and the composition and performance differences. Active investing anyone?

 

Picking Individual Stocks Is Better Than Index Fund Investing In Overvalued Markets

As you can see from the above, there are a number of reasons why the current environment is better for individuals investing in specific stocks as opposed to those buying the whole market via an index fund. Whilst index funds are the choice of many, I do have concerns for those good people with expectations that the S&P 500 will return the historical average of 10% because you won’t get that from a base of 26x earnings.

Buying individual stocks on the other hand allow you to cherry pick the right opportunities. This means that they are able to buy stocks that are trading below their intrinsic values. Using this method, I was able to get companies like Shell and BP at yields close to 10%. Picking individual stocks in the current environment has allowed me to comfortably beat the market whilst taking lower risk at the same time. As long as markets appear highly valued, individual stock pickers will continue to outperform.

Conclusion

People who possess exceptional talent in analyzing individual companies or macroeconomic environments should construct portfolios from their own individual selections. Those who lack these talents should own only low-cost ETFs on a strictly buy-and-hold basis.Is this all there is to say about investment strategy? By and large, yes. But with one important proviso.If you possess the resources to construct your own portfolio, roughly as diversified as the ETF you would otherwise purchase, you would be better off doing so. For three reasons:

  1. No matter how low the expenses of owning an ETF go, they will never go to zero.
  2. No ETF manager may be as smart as you think he is in achieving the return goals you expect. He may, for example, sell stocks which reduce dividends you were expecting, or generate capital gains you were not expecting.
  3. Most importantly, an ETF can subject you to co-investor risks you may have not thought about. A severe market downturn can produce investor demands for redemptions which the manager can only satisfy by selling assets at severely depressed prices. If you have never seen anything like this happen, you haven’t lived long enough.
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