Can an amateur identify winning stocks ?

Brendan Burgess

Brendan Burgess

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Friday's slump has unnerved equity investors. How long will this bear last? I've been hit hard like many others, and hold, among other shares Elan and Iona. It's difficult to keep faith in equities when there's little short term good news. Any views?



<!--EZCODE ITALIC START--> Title edited again as the subsequent debate changed completely<!--EZCODE ITALIC END-->
 
Still a way to go.

With the S&P 500 on an average P/E of approx 23, against its long-term average of 16, US markets would appear to have another 30% worth of a drop left in them. Coupled with a falling dollar and the fact that asset markets tend to overshoot, the fall could be harder.

On the positive side of things the yields on many US stocks are above that on US Bonds. Whether this is enough to halt the decline is really up to market sentiment.

UK equities valuations are said to look a bit more realistic. The FTSE's on a P/E of 20 but that’s against a long-term average of 12-13. The UK also tends to follow trends in the US quite closely. I’m not sure about the Eurostoxx 50 as its a recently created index. Maybe someone has someone has some figures of a comparable European index?

Some will argue that the prices don’t need fall, earnings just need to rise to realign markets to their long-term averages. However corporate earnings are still depressed and limited pricing power is likely to keep them from rapidly growing. Nervous accountants are also likely to reign in the “creation” of profit growth.

I know AAM contributors like to argue that equities are for the long-term. They are, in my humble opinion, quite right in this argument. However, with 2 years of decline in 2000,2001 and a near certain decline this year, many investors will lose faith and sell, asking themselves just how long is the long-term.

It would appear that tracking an index in the short to medium term is an unwise strategy given the current market outlook. Although Im sure many AAM contributors will agrue that now is the time to buy/cost pound averaging etc.

Stock picking would appear to be a better strategy for now. The big question is of course whether you can pick the right stocks!
 
Index vs Active

Hi Bearish,

Just curious as to why you think
<!--EZCODE QUOTE START--><blockquote>Quote:<hr> It would appear that tracking an index in the short to medium term is an unwise strategy given the current market outlook ... Stock picking would appear to be a better strategy for now. The big question is of course whether you can pick the right stocks!<hr></blockquote><!--EZCODE QUOTE END-->

The evidence I've seen suggests that index managers outperform most active managers in good markets as well as bad ones - ie that stockpickers find it as difficult to pick the right stocks when markets are falling as they do when they're rising.

Have you seen any data that refutes this view ?
 
Evidence

How about the fact that Warren Buffet is the 2nd richest man alive.

Im not knocking tracking an index over the longterm. Quite sensible altogether. Its just if you know something is likely to fall in the short-term it seems a bit silly to put your money into. I prefer to use my cash to pick up a few bargain shares myself. I've done a damn site better than both active managers and index trackers over the last year.
 
Indexing

Hi Bearish,

I agree that if you <!--EZCODE BOLD START--> know<!--EZCODE BOLD END--> something is going to fall in price in the short-term that it is silly to buy it. The problem is that you can't know any stock or index is going to fall in the near-term. You can suspect it, but you may be wrong. The evidence strongly suggests that where active managers invest on the basis of their ideas of what might fall and what might rise, they're wrong more than they're right - ie the don't beat (or even match) the indices.

Warren Buffett is also widely quoted (mainly by index managers, in fairness, but it's an accurate quote) as saying that the best way for an individual investor to invest in stocks is via index funds.
 
Re:Indexing

Dogbert,

Your quite right in saying that nobody can know where a market is going. However any serious analysis of the markets will show you just how overvalued they are. There’s a good article in today’s FT on this.

As for how you quoted Warren Buffet. He never said just tracking an index is the optimal strategy, he just said that this was the best strategy for the average individual with little time for research, or knowledge of the markets. His optimal strategy is that you buy great companies when they become undervalued and then hold them for a very long time horizon. This is value investing at its most effective. His problem with fund managers is that their investment horizon is too short and charges to high, but if you have the time and patience to do it yourself you can make a killing.
 
Re: Re:Indexing

<!--EZCODE QUOTE START--><blockquote>Quote:<hr> I know AAM contributors like to argue that equities are for the long-term. They are, in my humble opinion, quite right in this argument. However, with 2 years of decline in 2000,2001 and a near certain decline this year, many investors will lose faith and sell, asking themselves just how long is the long-term. <hr></blockquote><!--EZCODE QUOTE END-->

For me three years is definitely not "the long term". I feel that equity investment is suitable for investors with a minimum perspective of 7-10 years using cash destined for long-terml savings that is unlikely to be required at short notice.

tedd
 
Long wait

Tedd,

I don’t even think 7-10 years is long enough. If you have lost a nominal 30% percent over the past 3 years (which you would have if you invested in the Eurostoxx 50 in 2000), and we assume that the market picks up in Jan 2003 (a very big assumption in my opinion). its going to take another 3-4 years just to recoup your nominal losses assuming the market grows at around 8% p.a.( which I believe most actuaries are using as the equity’s markets long-term growth rate).

So by sticking out tracking the index for 7 years you end up gaining nothing in nominal terms and nursing a 30% loss in real terms! I don’t think individual investors realise this, and there will be a lot of disappointed people in 4 years when SSIAs mature.
 
Equity Markets

Hi Bearish,

Just a few points on this:

1. A bit like Troy in another thread, you seem to be blaming investment losses on indexation. Markets are down, index funds are down, active funds are down. If history is anything to go by, indexers will be doing better than most active managers.

2. On the SSIAs, don't forget that only a tiny portion of your ultimate investment is actually in the market now. So the loss you're carrying is tiny, and could easily be recouped in better markets going forward.

3. Yes, some commentators are saying the market is overvalued. Others are saying it's fairly valued, and others are saying it's undervalued. That's the way of stockmarkets. If everyone knew they were overvalued, we'd all be selling and no-one would be buying. Are there more negative views currently than positive ones ? Probably yes, but again that's the nature of markets. There were lots more positive views than negative ones three years ago when, in hindsight, markets were very overvalued.

Don't get me wrong - I'm not disputing that stockmarkets are facing lots of uncertainty at the moment, and that investor confidence is at a very low ebb. What I am disputing is your contentions that (a) investors can somehow find a certain way to take advantage of this - markets are reasonably efficient and price in all this uncertainty every minute of every day, and (b) active managers will take better advantage of these conditions than index managers - all the evidence points to the contrary being true.

If you made me bet, my guess would be that, with the benefit of hindsight, this will prove to be one of those periods of gloom which presented a good buying opportunity for long term investors, and I've been putting some cash back into the markets over the past nine months or so. But I accept I could be wrong on that.
 
Re: Equity markets

“What I am disputing is your contentions that (a) investors can somehow find a certain way to take advantage of this - markets are reasonably efficient and price in all this uncertainty every minute of every day, and (b) active managers will take better advantage of these conditions than index managers - all the evidence points to the contrary being true.”

a) I disagree with efficient markets. It can’t explain bubbles as if the market was totally efficient they would not arise. Closer to home I work across from a desk that makes millions exploiting market inefficiencies. They’d be out of business if the market was efficient.
b) I’m not disputing this. I am however saying that you yourself can do a hell of a lot better then either active or index managers over the long-term.

You appear to be contradicting yourself by stating that long-term studies have shown that tracking an index is better than active fund management (which I entirely agree with) while at the same time ignoring long-term trends in market valuations. Why do you attach such weight to the active v passive long-term studies while dismissing another long-term studies showing today’s market are overvalued relative to their long-run
 
Re: Equity markets

<!--EZCODE QUOTE START--><blockquote>Quote:<hr> I don’t think individual investors realise this, and there will be a lot of disappointed people in 4 years when SSIAs mature.<hr></blockquote><!--EZCODE QUOTE END-->

In relation to equity SSIAs, the AAM advice was quite clear that 5 years is probably the minimum period of investment suitable for equities, provided investors were not totally risk-averse. The possibility of needing to reinvest at the end of the 5 year SSIA period was also discussed.

For example, this very sensible pre-SSIA advice in a explains that
<!--EZCODE QUOTE START--><blockquote>Quote:<hr> In general terms, an equity investment is not a suitable vehicle to be in if you require your monies at a very specific time, as that time might be a point where markets are in a dip......Review your position after five years, and if markets are performing well at the end of the five year period, consider switching into a less agressive fund to consolidate gains made to date. If markets are down after 5 years, hang on.<hr></blockquote><!--EZCODE QUOTE END-->

I think that if someone is getting stressed about losses one year into a long term investment (even a SSIA) it's possibly a sign that equity investments may exceed their "risk tolerance".

regards
tedd
 
No Contradiction

Hi Bearish,

There's no contradiction in what I said, just two completely different things.

The outperformance of indexed over active managers is a <!--EZCODE BOLD START--> fact<!--EZCODE BOLD END--> which can be demonstrated. It can also be explained, specifically by reference to market efficiency and trading costs, so if you believe in indexing you may be more of a believer in efficient markets than you think you are. It's not an irreversible truth - ie the facts might change in the future - but for now it's an established fact, and can be regarded as such.

That the equity market is currently overvalued is an <!--EZCODE BOLD START--> opinion<!--EZCODE BOLD END-->, or an interpretation of data. The FT article by Martin Wolf to which you refer is cogently argued, and may well prove to be correct. But others interpret the same data differently, and gauge the valuation of the market differently.

Equity markets are reasonably efficient, in my view, although behavioural characteristics and the herd instinct make them susceptible to prolonged periods of over- or undervaluation - we've seen several obvious examples of that recently. The very fact that most active managers consistently underperform confirms me in that view. Given the talent and resources devoted to fund management, the lack of success seems to suggest that there are not many consistently exploitable inefficiencies available.

I suspect the successful colleagues to whom you refer are currency traders; it has been argued extensively in previous threads that currency markets are less efficient, because of the different motivations of participants.
 
Believe it or not

Hi Dogbert

Quote:
“The outperformance of indexed over active managers is a fact which can be demonstrated”

Which study are you referring to?

Quote:
“That the equity market is currently overvalued is an opinion, or an interpretation of data.”

A study is merely the interpretation of some raw data. I think you are contradicting yourself when you selectively accept the “interpretation of data” when it comes to active versus passive management, but not when it comes to market valuation? If a 20 year study based on historic data tells you that passive management is better then active management and you accept that, why do you find it so hard to accept that markets are overvalued based their 20 –30 year valuation averages?

Quote:
“Equity markets are reasonably efficient, in my view, although behavioural characteristics and the herd instinct make them susceptible to prolonged periods of over- or undervaluation - we've seen several obvious examples of that recently.”

You either believe markets are efficient or believe they are not. There can be no in between “reasonably efficient”. Your statement implied that you do not believe in market efficiency. Maybe you could clarify.

Just to clarify my stance, the reasons I don’t believe in market efficiency are as follows:

If markets are efficient , there is no possibility, except a random chance, that any person or group could outperform the market, and certainly no chance that the same person or group could consistently do so. Warren Buffets performance over the past 25 years is prima facie evidence that it is possible to outperform the market consistently. As for my friends on the other desk, they are not currency traders but equity arbitrageurs, who day in day out make their living from market inefficiencies. Believe me they are not the only ones doing this in the financial world.

The reasons why markets are not efficient is because:

1. Investors are not always rational. Efficient market theory assumes they are.

2. Investors do not process information correctly. They usually rely on shortcuts rather than fundamental analysis.

3. Performance measurements emphasize short-term performance, which makes it all but impossible to beat the market over the longrun.

As Buffet would say, efficient market theory makes no provision for investors who analyse all the available information and gain a competitive advantage by doing so. Academics by observing that the market was frequently efficient went onto conclude incorrectly that it was ALWAYS efficient. The difference between these too propositions is night and day.

Quote:
“Given the talent and resources devoted to fund management, the lack of success seems to suggest that there are not many consistently exploitable inefficiencies available.”

There are many market inefficiencies, however it is fund managers short term perspective that ensures they do not exploit these efficiencies. An individual investor can, so long as they are willing to take a long-term view.
 
Quick Reply

Hi Bearish,

Only have time for a quick reply now. As regards active versus indexed, pretty much any survey you like. Recent WM figures, for example:
* Over 20 years to end-2001, the FTSE AllShare index is in the top quartile of unit trusts investing with this mandate.
* Of the 51 unit trusts with a full 20 years of data, only 9 outperformed the index.
* In the year 2001, in a bear market, 36% of unit trusts outperformed the index - slightly fewer than had beaten the index in the average of the preceding 5 (mainly good) years.

It doesn't seem possible to me to construe this data, when taken alongside other corroborating data and matching it with a rational explanation for the data, as telling you anything other than active managers have not, in the aggregate, outperformed indices - ie that stockpicking is a loser's game in the aggregate. So that's a <!--EZCODE BOLD START--> fact<!--EZCODE BOLD END-->, it seems to me.

As regards the overvaluation argument ... maybe markets were actually undervalued on average over the previous period, maybe the variables that Wolf examined are not the critical ones, maybe there are factors at work currently which support higher valuations, etc etc. The <!--EZCODE BOLD START--> fact<!--EZCODE BOLD END--> here is that some indicators are showing higher readings than their long term averages. Some analysts conclude that means markets are overvalued. Other analysts disagree - ie draw different conclusions. So that's a matter of opinion, it seems to me. For what it's worth, I wouldn't disagree with you that the US may be overvalued, but I wouldn't regard it as a fact.

Will repsond to the efficiency point when I have more time.

Anyone else got any views on all this, or are Bearish and I ploughing a lonely furrow ?
 
Re:Quick reply

Quote:
“It doesn't seem possible to me to construe this data, when taken alongside other corroborating data and matching it with a rational explanation for the data, as telling you anything other than active managers have not, in the aggregate, outperformed indices - ie that stockpicking is a loser's game in the aggregate. So that's a fact, it seems to me.”

These studies (which by the way I entirely agree with) do not say that stock picking is a losers game. They say that stock picking by FUND MANAGERS is a losers game. You need to be very careful that you do not confuse stock picking as performed by an individual investor with stock picking performed by a fund manager. I entirely agree that passive fund mangers have over the past 20 years outperformed active fund managers. I don’t agree, nor have you presented any evidence to support the proposition that stock picking by INDIVIDUALS will not beat tracking an index.

One another point on index tracking. Most of the studies carried out have been over a 20 year time horizon from 1980s to 2001. During this time markets experienced their longest bull run in history, with the effects of a bear market only been felt in the last 1.5 years. You could argue (but I’m not) that its no wonder index trackers did so well over this period. Unfortunately you can’t do any time studies before 1980 as trackers weren’t really around then. It will be interesting to see what studies in the future yield.

Quote:
“As regards the overvaluation argument ... maybe markets were actually undervalued on average over the previous period, maybe the variables that Wolf examined are not the critical ones, maybe there are factors at work currently which support higher valuations, etc etc.”

There is a lot of maybes there Dogbert.


Look forward to hearing your efficiency argument.
 
'nother opinion

Here is my humble opinion Dogbert/ Bearish.

On active management, there is no disputing the underperformance of active managers and their collective inability to (consistently) beat the index. It does not follow that active management is redundant and buying the index is the best investment option.

Active Managers may underperform in both positive and negative markets, but the chances of outperformance through active management are much improved when markets are exhibiting greater volatility, as they currently are. This is the time when markets are more likely to exhibit irrational behaviour, detach themselves from fundamentals and create opportunities for stock pickers.

The bear market that is referred to in this thread has been predominantly a large-cap phenomenon. In the small/ mid cap arena, there has been a strong bull market playing out over the last 2 years. As such advocating an index approach over the last 2 years has been the worst kind advice, given that most passive fund options are large cap index trackers.

The market efficiency question has been fairly conclusively argued IMHO. Markets are not efficient.
Markets often detach themselves from fundamentals, and often for long periods of time. The overvaluation of the late '90's, the undervaluation of the early '80's, is testament to this. Using fair value models to predict stockmarket exit and entry points would have destroyed value for investors if one had decided to exit the market in 1996, notwithstanding the subsequent crash.

Despite the sharp decline in share prices, markets are currently overvalued relative to history. The P/E's quoted earlier in this thread are undisputedly high. Despite the fall in the ‘P’, the 'E' in this equation is cyclically depressed, coming from a high base. There has also been no mention thus far of the fact that in an era of higher productivity growth and lower inflation, higher multiples for stocks can be justified. We have had some very strong recent evidence in the US of continued productivity gains, which has translated into a fall in unit labour costs. Inflation is in check, bond yields are exceptionally low, as such the discount rate is low. So a blanket comparison of P/E’s today relative to an era when bond yields were twice as high is biasing the bear case.
 
Lots of Maybes - Reply to Bearish

That was precisely my point, Bearish - there <!--EZCODE BOLD START--> are<!--EZCODE BOLD END--> lots of maybes on the valuation issue, no maybes at all on the active versus passive issue. So I'd regard one as a matter of fact and the other as a matter of opinion.

You're right that I was focussing on the track record of investment firms, not individual investors. The only data I've seen for individual investors shows their record to be very poor - worse even that investment firms - but this related to online brokerage accounts, and so may reflect the day-trading rather than the buy-and-hold mentality. If you have any data on the latter, I'd love to see it. But I'd caution you against thinking that there are lots of Warren Buffetts out there - I think he stands out because there are <!--EZCODE BOLD START--> not<!--EZCODE BOLD END--> many investors like him.

In any event, there's a simple truth we can fall back on here. The total return to all investors over the long term is the market return minus their costs of participating in it. Indexers get the index return by definition (they probably pay a very small cost to get it). So if some investors are to outperform (a la Buffett) they're getting that outperformance at the expense of others. From what I've seen, active managers underperform in the aggregate mainly because of the costs they incur, as indeed do day traders. So while there will certainly be some "excess" return distributed among the successful investors, it may not be that great. I suppose all this comes back to the degree of efficiency you think markets have, and the consequent availability or otherwise of exploitable profit opportunities.
 
Reply to Fairfield

Hi Fairfield,

I agree with a lot of what you say. Certainly, more volatile markets, especially narrow ones, provide greater scope for outperformance by investors who pick the right stocks ... and greater scope for underperformance by those who pick the wrong stocks. But it doesn't make picking the right stocks any easier. So I'd expect to see a greater spread of performance, but not necessarily any greater number of managers outperforming. As I pointed out earlier, 5% fewer UK managers beat the index in the down market of 2001 than had done so in the average of the preceding five up years.

Your point about small cap versus large cap is accurate, and valid. Fund managers tend to be over-exposed, relative to indices, in small cap stocks. So a good period for small caps should help them. But I haven't seen much evidence of it so far. It may argue for indexing to a broad rather than a "top 50/100" index, though.

Your final point is exactly what I was trying to get across to Bearish. Markets are dynamic, and hence simple comparisons of statistics, especially a relatively blunt instrument like the p/e ratio, are unlikely to capture the whole picture. That's why I would characterise valuation as a matter of opinion rather than fact.
 
Market Efficiency

Said I'd get back to this so here goes.

I think it is possible to have degrees of market efficiency, indeed the academic stuff allows for this. Clearly, markets are not entirely efficient - the internet bubble, the January effect, merger arbitrage opportunities, etc prove this without a doubt. I also agree with Bearish about investor psychology being irrational in some respects, and about fund managers herding and taking short-term decisions.

My view is that the level of resources and talent devoted to analysing financial markets makes them sufficiently efficient (I said "reasonably efficient") that it is <!--EZCODE BOLD START--> very difficult<!--EZCODE BOLD END--> to identify and act on profitable inefficiencies. Stock prices reflect all known data and the aggregate opinions of investors about that data. The aggregate opinion of investors sometimes gets over-positive or over-negative about prospects and that overreaction can last for some time. So there are clearly opportunities to sell into the over-optimistic markets and buy into the over-pessimistic ones, which will provide profit opportunities for those smart, and brave, enough to take them. It ususally means moving dramatically against the herd. But it's certainly do-able. I suppose this brings me into agreement with Bearish and Fairfield. But my gut feeling is that if it were not very difficult indeed, we would have a lot more examples of success.

Bearish will counter that professionals are undone by their need to be right quarter-on-quarter, which prevents them from making the correct long-term decisions, and there certainly is an element of that. But in the absence of data to prove it, I'm not convinced that there are large numbers of private investors successfully capitalising on the mistakes of the professionals. Again I'd welcome other views.
 
Focus Investing & P/Es

Dogbert,

I think we’ll just have to disagree on the valuation issue.

As for the data relating to online brokerage accounts, Id say that as these accounts have only been around for the past 5 years the time period of the data would be too short to make any conclusions. I’d agree with you that the presence of day traders would also seriously distort any such study. Unfortunately I haven’t seen any studies comparing individual value investors against passive and active managers. Personally I don’t think it would be easy to carry out such studies. I however believe that the track record of people like Buffet is evidence enough. Other well known individual focus investors have included John Maynard Keynes who had sole responsibility for his Chest Fund achieved an average annual return of 13.2% from 1929-1945, when the UK market remained mainly flat (-0.5% p.a.).

Quote:
“Indexers get the index return by definition (they probably pay a very small cost to get it). So if some investors are to outperform (a la Buffett) they're getting that outperformance at the expense of others.”

The “others” they are getting that outperformance from are the same active managers which you have correctly highlighted underperform the market. Following your argument to it conclusion - given that active fund managers massively underperform the market there seems to be plenty of “excess” returns to be distributed to the smart investor who is willing to patiently wait for a bargain and hold for the long-term.


Fairfield,

Quote:
“Despite the fall in the ‘P’, the 'E' in this equation is cyclically depressed, coming from a high base. There has also been no mention thus far of the fact that in an era of higher productivity growth and lower inflation, higher multiples for stocks can be justified. We have had some very strong recent evidence in the US of continued productivity gains, which has translated into a fall in unit labour costs. Inflation is in check, bond yields are exceptionally low, as such the discount rate is low. So a blanket comparison of P/E’s today relative to an era when bond yields were twice as high is biasing the bear case.”

While I agree with you that significant productivity gains have been made in the US, I would argue that these gains have not necessarily gone onto benefit corporate earnings, but have been passed onto the consumer via lower prices, hence the low rate of inflation. Corporates ability to increase earnings via price rises is somewhat limited in today’s competitive market places. I therefore don’t see any real justification for today’s high P/Es based on the ability of companies to aggressive grow earnings in the future.
 
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