Why Picking Stocks Can Improve Your Portfolio
Life is not in the Averages
The prevailing wisdom is that no one can beat the market. After all, only one-third of professional fund managers have outperformed index-fund benchmarks over a 10–15-year period. If even professionals cannot beat the market, then you should only invest in index funds. I used to believe this too and I doubted whether successful stock-picking was even possible.
Until I worked in the world of equity research.
On Wall Street, we look for companies that can outperform (or underperform) their peers and the market’s returns. Can analysts identify some of them? Yes!
I can tell you that when the fundamentals (quality of the business, industry dynamics), the expectations (what investors expect), and the valuation (the price of the business) are aligned in a certain way, the stock is more likely than not to outperform.
If that’s the case, then why do most professional fund managers underperform?
The simple answer: Most of these funds are not offering much in stock-picking, to begin with. I realized most professional investors have constraints that limit their ability to pick stocks.
Most active managers offer portfolios of specific styles or exposures. These are often exposures by market, company size, or industry. Today, an index, which is calculated automatically by a computer, can create these exposures, at a much lower cost. Other investment styles, such as value or quality, can also be created by an index. Since the active mutual fund charges 4–6x more — between 0.25% to 2% of assets, versus 0.04% to 1.6% for an index fund, the returns from those exposures will be lower. Most of these funds have seen their assets decline as investors have moved their money to low-cost index funds or exchange-traded funds (ETFs) for specific exposures.
Unconstrained portfolios are where you can see outperformance. You see the signs of stock-picking when a fund offers a different strategy to the index. Funds with higher active share, meaning their portfolios differ more from the benchmark index, tend to have higher returns (higher risk as well). The performance of active funds also tends to increase when portfolios are concentrated in the top one or two stocks within a sector. To see the returns (and skill) of picking stocks, you need the leeway to select different companies and concentrate on positions.
Individual investors, on the other hand, are free to pick any stock, which provides lots of opportunities. Arguably, I’d say the individual investor has a better chance of outperforming the market with stocks when given the right training.
The question is, where do we find these opportunities?
Making Bets for Life-Changing Returns
Here’s a secret I learned from investing: all it takes to achieve life-changing returns is one or two well-placed bets with a portion of your capital. It seems throughout history the best businesses tend to grow their profits faster and far longer than other companies. Not only that, but the best companies also seem to show increasing investment returns as they achieve greater scale.
In a study of the U.S. stock market, researchers found that 4% of stocks have accounted for nearly all wealth creation since the 1920s. It’s even more extreme internationally, with less than 1% of stocks accounting for all wealth creation since the 1990s.
In the stock market, power laws are visible when you look at the pattern of returns. Meaning a small handful of companies will radically outperform all others. It also applies to time as well — with a few days also accounting for most returns.
The returns of a few stocks (over a few days) will drive the returns of your portfolio.
This, by the way, is why investing in an equity index fund works. By investing in a wide universe of stocks, you increase the likelihood of finding one of these winners. Since the index is usually market-capitalization weighted, the fund will increase its position as the company grows larger. Then by holding the fund and keeping money in the market, you don’t miss out on the key days when the stock price will move.
The other implication is that an investor also has an opportunity to find a few investments with vast potential to drive returns for their whole portfolio. Get the right stock and the payoffs are huge.
So why not do both? Invest in index funds and do stock picking. I’d argue that if the upside is that large for a few select stocks, it makes sense to allocate a portion of the portfolio to picking stocks.
Let’s compare three five-year scenarios where you pick an individual stock. Imagine you start with a $10,000 investment portfolio in April 2016. We’ll take 10% of the portfolio ($1,000) and invest it in either 1) a unique leader in an industry, 2) a leader in the index, or 3) a random stock that unfortunately goes bankrupt. In other words, we either: found a real unique winner, concentrated on a market leader, or picked a stock that went to zero.
Here are the stocks we’ll use.
Unique Leaders of Industries (2016)
Professional Services: CoStar ($CSGP4): In 2016 CoStar had the largest [CB2] collection of commercial real estate data. This included places for lease, sales information, properties for sale, tenants’ information, and so on. CoStar had actively acquired data providers and marketplaces to build this data collection. Few alternatives were as comprehensive. You recognized CoStar’s advantages of owning proprietary real estate data. You knew it had limited competition, which would mean CoStar’s operating margins (25%) could remain at higher levels. You looked at the margins of other real estate businesses, such as brokerages (15%) or commercial developers (15%). In those companies, you saw higher costs and more competition. CoStar stood out to you as a company with limited competition.
Capital Markets: MSCI ($MSCI): The U.S. Department of Labor expanded fiduciary requirements for financial advisors in 2016. Advisors were now expected to recommend low-cost products such as exchange-traded funds or index funds. These were provided by either BlackRock or Vanguard. These funds create portfolios using indexes from the largest providers, S&P Dow Jones Indices, FTSE Russell, and MSCI. The reliance on indexes meant funds rarely switched index providers. You recognized the MSCI’s index business model would be embedded in the growing index fund ecosystem. It suggested a dominant high-margin position.
Biotechnology: Exact Sciences ($EXAS): In 2015, the Cancer Society recommended a new genomic test called the Cologuard. The test was developed by Exact Sciences. It was a more comfortable alternative to the traditional colonoscopy. If you had undergone a colonoscopy or knew someone who had, you likely heard of this less-invasive test. At the time, Cologuard represented roughly 5% of colonoscopies5 in the U.S. You recognized this was the time to invest for the acceleration in Cologuard’s market adoption.
Specialty Retail: Restoration Hardware ($RH): In 2016, Restoration Hardware was several years into a new growth strategy. CEO Gary Friedman planned to transform the business into a modern, upscale furniture brand. If you followed the retail consumer sector, you heard of his earlier success at Williams-Sonoma. He grew the business from $300 million to $2.1 billion using product presentation strategies. Under his leadership, Restoration Hardware achieved industry-leading revenue and earnings growth rates. It transformed its real estate presence with new product offerings. You recognized the unique leadership of Gary Friedman and the financial potential of the company’s growth strategy.
Here are the returns (April 2016–April 2023) of $1,000 of these unique leaders’ stocks:
• CoStar ($CSGP): $1,000 to $3,700
• MSCI ($MSCI): $1,000 to $7,500
• Exact Sciences ($EXAS): $1,000 to $9,600
• Restoration Hardware ($RH): $1,000 to $5,500
The Leaders of the Index (2016)
Apple ($APPL): In 2016, Apple was the smartphone market leader. You saw the Apple iPhone and MacBook every day. The ecosystem of Apple products and services was expanding. There was growth in emerging markets, new products like the Apple Watch, and a growing services business. Warren Buffett’s Berkshire Hathaway had just made a significant investment in the company. The Apple ecosystem was starting to look like a subscription for consumers.
Google ($GOOGL): Google was the number online search and video platform. This was a dominant market position with network effects. Google had recently separated these advertising-driven businesses from its venture-related investments. You could see the very profitable economics of the internet search and video business.
Microsoft ($MSFT): Satya Nadella had recently taken over as CEO of Microsoft. He shifted the company’s strategy toward enterprise and cloud-based services. The strong growth of Microsoft’s cloud and Azure business suggested a new growth business. You could see the large enterprise software market opportunity for the company.
Here are the returns (April 2016–April 2023) of $1,000 of these index leader stocks:
• Apple ($AAPL): $1,000 to $6,000
• Google ($GOOGL): $1,000 to $2,700
• Microsoft ($MSFT): $1,000 to $5,100
The Random Stock that Goes to Zero (2016)
Worst-case scenario, we picked the stock of Wirecard, a company that turned out to be a fraud.
Getting More Upside than Downside
Let’s compare the returns of the three scenarios and assume you invested the remaining $9,000 into an S&P 500 Index fund like $SPY. ($9,000 invested in $SPY turned into $18,000.)
Best case: You prepared yourself to recognize profitable patterns. You pick $MSCI to invest $1,000. Your portfolio goes from $10,000 to $25,000 (150% return).
Worst case: The stock you pick goes bankrupt to $0. Your portfolio goes from $10,000 to $18,000 (80% return).
Lazy case: You pick one of the leaders of the S&P 500 index (we’ll use $GOOGL). Your portfolio goes from $10,000 to $20,000 (105% return).
Baseline: You don’t pick any individual stocks and invest everything with the S&P 500 index. Your portfolio goes from $10,000 to $20,000 (100% return).
There is much more upside than downside in the potential scenarios. The best-case returns of 150% are much higher than the worst-case returns of 80%, in this index plus stock-pick portfolio (versus 100% baseline). The downside of a bankrupt stock is zero (-100%), but the potential upside of a winning business can be much higher (over 1,000% for select stocks).
Admittedly, I am biased toward stocks, given my background. Still, I believe there is an asymmetric opportunity in stock-picking that can be profitable for your portfolio as an investor.
The next step then is learning to recognize a great stock, then allocating an appropriate amount of capital. Coincidently, this has been an obsession of mine for the past decade or so — to understand the principles of the stock-picking.
And I’m excited to share this with you!
Connect with me here: www.henrychien.com
Notes
This way of thinking is similar to the barbell concept introduced by Nassim Nicholas Taleb in his book Antifragile: Things that Gain from Disorder. The barbell strategy places 90% of funds in boring cash or other repositories of value and the other 10% in something maximally risky. The structure protects you from extreme downside and allows for a much larger upside. You let the positive black swans take care of themselves. Investing in a leading business is one way to create asymmetry in potential outcomes.
References
Cremers, Martijn, and Antti Petajisto. “How Active Is Your Fund Manager? A New Measure That Predicts Performance.” SSRN, March 21, 2006. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=891719.
Bessembinder, Hendrik. “Wealth Creation in the U.S. Public Stock Markets 1926 to 2019.” SSRN. W.P. Carey School of Business, February 25, 2020. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3537838.
Bessembinder, Hendrik, Te-Feng Chen, Goeun Choi, and K.C. John Wei. “Do Global Stocks Outperform U.S.S. Treasury Bills?” SSRN, July 9, 2019. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3415739.
Goldman, Eitan, Zhenzhen Sun, and Xiyu (Thomas) Zhou. “The Effect of Management Design on the Portfolio Concentration and Performance of Mutual Funds.” Taylor & Francis, December 27, 2018. https://www.tandfonline.com/doi/full/10.2469/faj.v72.n4.9.
Arthur, W. Brian. “Increasing Returns and the Two Worlds of Business.” SFI WORKING PAPER: 1996–05–028. Santa Fe Institute, n.d. https://www.santafe.edu/research/results/working-papers/increasing-returns-and-the-two-worlds-of-business.
Taleb, Nassim Nicholas. “Never Marry the Rockstar: Seneca’s Barbell.” Essay. In Antifragile: Things That Gain from Disorder, p.161. New York, NY: Random House, 2016.
