***Off Topic*** Chuck's computer screen.
Chuck, here's an article posted on SI that agrees with your point of view:
techstocks.com
Mar 04, 1998
Outperforming The Investment Professionals - An Impossible Goal?
Joe Dancy of The Lone Star Growth Investor members.aol.com provides the following commentary. Subscriptions to his newsletter are FREE. Click here for more information. Below is his write up.
OUTPERFORMING THE INVESTMENT PROFESSIONALS - AN IMPOSSIBLE GOAL?
By: Joe Dancy, Lone Star Growth Investor
"Over the last decade around 80% of investment newsletters - and a similar percentage of money mangers - failed to beat the Standard & Poor's 500 index according to Mark Hulbert, editor of a service that monitors investment newsletter performance.
Last year the performance was even worse. According to Barron's, the S&P 500 beat around 90% of the diversified U.S. equity funds. The typical fund underperformed by around 9% - a major gap in anyone's book. In only three of the fast fifteen years have more than one-half of all mutual funds outperformed the S&P 500.ÿ
As an individual investor, if you didn't think you had a significant chance of outperforming this index you could invest in an index fund that mimics the S&P 500 index - and save the time, risks, and associated costs involved in selecting individual stocks or the misery of attempting to identify mutual funds that may outperform.
Non-the-less, even with these dismal statistics we are convinced that individual investors - if they have a coherent investment strategy - have a significant chance to do what many professionals have not - outperform the S&P 500.
THE FUTURE IS NOW
Why are we so optimistic?
First, we are living in a global economy - one in which information and technology has become essential in both the production of physical products and to the creation of wealth. How far, and how fast, we have come is illustrated by the fact that the first transatlantic cable capable of carrying voice transmissions was not laid until 1956 - and could carry a grand total of 36 conversations at one time. Today the internet carries at least five times the number of messages as the U.S. Post Office - and can instantaneously send these messages almost anywhere in the world.
The global economy has increased the value of information and technology - and allowed individual investors worldwide to participate in the wealth created by companies that harness this intellectual capital. Governments with aggressive taxation and regulatory policies will see companies and their investors leave to more friendly environments, since this technology has made business more mobile and less reliant on one central location.
Advances in information technology will also empower ordinary citizens. For example, a person who could not obtain a certain non-FDA approved medication in the U.S. can order it via the internet from legitimate companies operating in Mexico or Europe. Investors in New Zealand, for example, now can get immediate information on companies traded on the U.S. NASDAQ - and make investment decisions accordingly - transmitting orders electronically over the internet to be executed seconds later half a world away.
The individual investor is entering a new era - an era of financial information - and for the first time in history this information is available to individuals over the internet on a scale never before imagined. Only the larger institutions historically have had access to financial databases, screening tools and the like. Now individuals using these tools wisely they can fish where institutions, because of their size, cannot.
Many of the dynamic companies in these sectors are overlooked by traditional Wall Street analysts
The seeds of the information revolution are just now being planted. Although around one-half of the households in the U.S. have a computer, only around 25% of those households have access to theÿ internet. Internet connections are even lower elsewhere: 7% of the households in Germany have an internet connect, 6% in Japan, 5% in the U.K., and 2% in France. Only a fraction of those who have a connection utilize the internet for financial research - although these numbers will increase substantially in the years ahead.
Individuals can use on-line information to become experts on expanding areas of the economy - areas where technology will drive growth much faster than the worldwide economy. Many of the dynamic companies in these sectors are overlooked by traditional Wall Street analysts. Further, the number of small public companies available to the individual investor has swelled by 40% or more in the last six years - many have been listed on NASDAQ and have little institutional following yet have tremendous growth potential.
Finally, when looking at the total after tax return, an investor selecting their own stocks has much more control over annual tax liabilities and in turn the return on investment. By controlling the buying and selling decisions an investor can control when any gains are recognized - and when tax liabilities accrue.
Below we review investment alternatives, and explain our theory of why the individual investor has a significant chance to outperform the investment professional in the information age.
THE BENCHMARK S&P 500 INDEX
The S&P 500 index is a capitalization weighted index composed of 500 companies in the industrial, transportation, utility, and financial sectors. It has been used by commentators and industry professionals as a proxy for the market and for larger capitalization stocks.
Index funds tracking the S&P 500 are readily available to the individual investor, and over the last four or five years the S&P 500 index has outperformed most other market indexes - in some cases by quite a good margin. If recent history is any guide, if an investor can beat the S&P 500 index than they will be doing quite well.
THE MUTUAL FUND ALTERNATIVE
Professionals are managing an increasing share of the public's liquid assets. Mutual funds own almost 30% of all U.S. equities now - up from 3% twenty years ago. If we can find a viable alternative to individual portfolio management that will maximize capital appreciation - or at least one that has an even chance of matching the performance of the S&P 500 index - then a time consuming individually managed investment program may not make much sense.
You would think that it would not be that difficult for these professionals to outperform the S&P 500 index. They have all the high tech tools, expertise, and the economies of scale to work with. The S&P index is, after all, only a basket of 500 stocks.
Lately, this has not occurred. John Bogle, Chairman of the Vanguard Group, noted that the average stock fund has trailed the S&P 500 index by an average of 1.8% a year since 1981. He further predicts that the performance gap between the S&P 500 index and equity fund returns will likely widen. Fees and transaction costs amount to about 2.5% a year drag on performance at the average fund according to Vanguard. "Money managers are getting rich, but they're creating negative economic value" because they are generating sub-market returns according to Bogle. Capital gains taxes reduce the reported return further - by another 1.4% or so according to the Vanguard Chairman.
Why the underperformance? There are a number of explanations offered.
First, the average turnover rate in an equity fund is a healthy 90% a year - meaning that the entire portfolio is almost replaced every year - a turnover rate three times higher that it was two decades ago.
The massive size of many mutual funds also limits performance by restricting what stocks a fund can economically purchase; large funds cannot take a major stake in many of the faster growing smaller companies. If a fund takes a stake in these growing companies the impact on the overall performance of the fund many times will be negligible. Twenty years ago funds managed $34 billion - today the industry manages over $2.2 trillion.
Then there is the mutual fund tax problem. A study conducted by Stanford University Economist John Shoven recently indicated that taxes ate up 40% or more of the long term returns from a typical mutual fund. The problem stems from a requirement that mutual funds pass 98% of their capital gains along to investors each year, plus any interest or dividends. So even if the mutual fund shares are bought and held, the investor owes taxes on the gains realized by transactions in the fund's portfolio. And since the market has had some big gains over the last several years, the taxable distributions can be quite significant.
The point here is not to embarrass equity funds and their fund managers. Mutual funds can be an excellent investment for individuals that don't have the time or interest in active portfolio management - which apparently is most of the U.S. population. Some funds will do better than others. There is nothing wrong with letting professionals manage your money. Just be aware that professionals, even with their expertise, don't always outperform.ÿ ÿ ÿ
INVESTMENT NEWSLETTERS
Investment newsletters are not constrained by portfolio size, trading expenses, or by investment restrictions, so you would expect that investment newsletters should perform relatively well compared their equity mutual fund cousins. In actuality, investment newsletters have not done much better than the active money managers.
Researchers at Duke University and the University of Utah reviewed the advice given by 326 investment newsletters between December 1990 and December 1995 - and found that if you followed the average newsletter's advice it would have yielded an average annual return of 12.6% over that five-year period.
In contrast, the study's authors said, their own "passive" buy-and-hold investment model produced an average annual gain of 16% in the period - and the passive portfolio was only 70% invested in stocks and the remainder in Treasury bills. During the same period the S&P 500 index had average annual returns of around 14.5%.ÿ
The conclusion of the study? Only 16.5% of the newsletters - one in six - "provided valuable investment advice," said Campbell Harvey, a professor of finance at Dukeÿ University's Fuqua School of Business.
To meet the goal of outperforming the S&P 500 index an investor needs a system to identify attractive undervalued companies
Similar results were obtained in a study released by Mark Hulbert of the Hulbert Financial Digest. Of the 20 investment newsletters with records going back to 1980 only three beat the S&P 500 index - not very good odds.
Hulbert notes that "discipline is the great unsung virtue" of successful investment advisors. "The best newsletters follow a disciplined investment style - it doesn't matter all that much what style that is and stick to it in the bad times" according to Hulbert.
Likewise James O'Shaughnessy, president of O'Shaughnessy Capital Management and author of "What Works on Wallÿ Street," has noted that the most valuable newsletters are those that offer investment strategies that have been tested over long periods of time, and that have the discipline to stick with their strategies without allowing emotion to get in the way.
To meet the goal of outperforming the S&P 500 index an investor needs a system to identify attractive undervalued companies. Preferably, such a system should be based on factors that historically have lead to portfolio outperformance. Last, and probably most important, an investorÿ needs to feel comfortable with the strategic investment plan in order to execute it with the discipline needed to succeed.
INVESTMENT ANOMALIES FOR THE INDIVIDUAL INVESTOR
Geologists in their search for oil or gas look for geological "anomalies" where hydrocarbons may be trapped by naturally occurring geological conditions. Likewise an individual investor can look for investment anomalies to find value trapped, unrecognized, in the market.
Like the oil exploration effort, there is always the possibility of a "dry hole" but financial, valuation, portfolio, and market risks can be reduced in our venture - just as drilling risks can be diversified over a number of prospects in different areas.
In the oil business computer generated three-dimensional seismic images, directional drilling developments, new fracturing technologies, and other technological advances have made exploration much less risky and profitable for the explorationist. Likewise, technological advances have made the "exploration" for attractive investments less risky and potentially more profitable for the small investor.
We are convinced that if the on-line information is used wisely it can identify publicly traded companies - especially smaller companies not followed by many analysts or institutions - that are extremely attractive as potential investments. And like oil field advances, we are convinced that these tools will allow investors to make decisions that could be very profitable.
ANOMALY NO. 1: IGNORED SMALLER COMPANIES
The number of publicly traded companies exploded during the 1990's. T. Rowe Price indicates that 11,400 companies are publicly traded as of the fall of 1997 - up from around 6,100 in the early 1990's. Over one-half - 6,250 - are companies with market capitalizations of less than $100 million.
By some measures it has been argued that the quality of the smaller publicly traded companies has been diluted with all of the offerings. From a purely economic standpoint the supply of small cap equities has increased substantially, and demand had not increased to the extent that supply has, which reduces the value. On the other hand, the number of growing companies available to investors, and the information on them, has never been greater.
Over longer periods of time smaller capitalization stocks tend to outperform. Compounded annual returns of small caps from 1940-1991 was 15.7% - versus annual returns of 11.8% for large cap stocks according to data from Ibbotson Associates. Other studies also indicate small caps tend to outperform over time.
Technology -whether with regard to electronics, semiconductors, telecommunications, drugs, or otherwise -ÿ tends to provide a catalyst in which explosive growth can occur.
A number of reasons are given for this outperformance. First, small cap stocks tend to be ignored or neglected by institutional investors. For example, mutual funds are generally restricted so that they generally cannot purchase much more than 10% of the shares of any publicly traded company. As such, a fund taking the maximum position in a small company will be limited in the amount of money it can commit - and even if the stock triples the impact on the fund will be inconsequential. As more money flows into mutual funds fewer and fewer managers find that it is worthwhile to deal with these smaller companies.
A small investor on the other hand is under no such limitation. They can invest in any size corporation - and the performance of the company they invest in will have a direct and possibly significant impact the value of their net worth (unless they are Warren Buffett, Ross Perot, or the like). The relative absence of institutional investors creates opportunities for the investor willing to do the research necessary to identify these companies.
Institutions and larger investors cannot, or do not utilize much of the information available on smaller companies. The individual can thus become the "expert" in evaluating investment opportunities in this sector. This is especially true when dealing with technology. Technology -whether with regard to electronics, semiconductors, telecommunications, drugs, or otherwise -ÿ tends to provide a catalyst in which explosive growth can occur.
ANOMALY NO. 2: A LONG TERM FOCUS ON EARNINGS POTENTIAL
One of the primary assumptions that we make when examining potential investments is that earnings will be directly correlated with the price of the stock. Hence, as long term investors we want companies that have the potential to grow briskly, but do not want to purchase an overvalued entity.
Institutional money managers are operating under extreme pressure to perform in the short term. An institutional investor cannot buy a severely undervalued and under-preforming growth stock and hold for three to five years for fear of adverse short term investment results. As such, many institutions are forced to actively trade on a company's "relative strength" and earnings "momentum" to attempt to capture short term gains. In addition, cash continually flows into and out of funds -forcing the fund manager to execute a number of transactions to keep the fund balanced and to maintain adequate reserves to meet the expected redemptions.
One of the major advantages of the individual investor is the ability to focus long term -and buy great growth companies that may be temporarily under-performing because the "sector" is not in favor or for some other short term company-specific reason.
The big question is how does an investor accurately estimate the projected five year annual growth rate of a company's earnings? There is no answer to this question, but as an investor can look at a number of factors including the following:
1. Analyst Estimates. While it pays to be skeptical of most analyst estimates, especially when the company is only covered by two or three, the consensus long term earnings growth rate as calculated by analysts who cover the company is a good place to start when evaluating growth prospects.
2. Revenue Growth. Generally it is easier for a company that is increasing revenues to also increase earnings. If revenues are stagnant, earnings can be increased by cost cutting or by increasing margins - both of which are tough to continue over longer periods of time. So if revenues are not growing at 15% a year or more, earnings may not grow that fast either.
3. Industry Outlook. A company in a dynamic, growing industry, will usually have an easier timeÿ meeting earnings projections than one in a stagnant industry. With revenue and volume growth earnings generally will be easier to grow if the company has a niche. If we are wrong in our analysis the company may be an attractive acquisition candidate to others in the growing sector.
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4. Company Size. By their inherent nature smaller companies have the capability of growing earnings faster than larger ones - although the risks may be higher in a company with limited resources. Small and microcap companies, if they have the management expertise, financing, and products, are more likely to meet higher growth estimates.
5. Historic Trends in Earnings/Margins. Earnings and margins that have been increasing in a somewhat predictable pattern may substantiate an analyst's opinion that such trends will continue in the future. If margins are decreasing, then revenue growth should be sufficient to drive earnings growth. Earnings and margins that fluctuate randomly make it more difficult to put faith in attractive growth predictions.
6. Product/Service Attributes. If the company has a niche with regard to their product or service that is not easily borrowed by a competitor, the probability of long term sustainable earnings growth is enhanced.
ANOMALY NO. 3: TAX MANAGEMENT IMPLICATIONS
Most mutual funds are managed as if taxes were irrelevant. Investors are taxed both on the fund's income, which tends to be minimal, and on capital gains. The individual is generally at the mercy of the fund manager in any given year.
Since most institutional money managers are compensated on their before tax return, managers generally have little concern for the tax implications of their transactions. If investment funds are kept in a taxable account, an investor may even be taxed on gains that were built up in a mutual fund before they invested. With the average turnover of most funds approximately 100% a year, tax implications can be significant -and the actual return on the investment is reduced.
Individual investors in stocks will have to pay taxes on capital gains or income, of course, but have they a huge advantage -they decide when to take these gains (or losses), and can offset gains with losses to minimize the financial impact. And of course, capital gains are not incurred until a stock is sold -and the investor can control when this taxable event occurs thereby deferring tax payments.
ANOMALY NO. 4: INDIVIDUAL RISK MANAGEMENT & OPPORTUNITY COSTS
Investing is not a risk free activity. Smaller companies in the technology sector can be about as volatile as they come - so the investor must have an idea how to manage risk and incorporate these concepts in an investment plan. Every individual has their own level of risk they feel comfortable with. Here are some ideas on this matter, and the tools which can be used to address this issue.
1. Time Diversification. The economy as well as the market fluctuates periodically, sometimes dramatically. Historically, however, the longer a stock is held the less chance exists that a party will lose money. As such, to reduce risk an investor should plan on holding a stock for a long term period, preferably for at least five years. Due to the long holding period involved, stock selection becomes extremely important.
2. Value Based Selection. By identifying and purchasing severely undervalued growth companies the financial risk is reduced. Companies whose stock price is low compared to its underlying book value, who have low debt/equity ratios, low historical and projected price/earnings ratios compared to earnings growth, assist in putting a floor under the stock price. A company undervalued to begin with should not decline in price much below book value in most cases -in such a case a company becomes an attractive takeover or buyout candidate if it is positioned in a growing industry. Further, studies have indicated that undervalued companies fall less than higher valued cousins when the market declines or disappointing news is announced.
3. Diversification of Holdings. Any given company or industry segment can experience problems due to internal or external financial, economic, or political events. Studies have shown that eight stocks in different industry groups diversify around 81% of the risk of holding an individual stock. Holding at least eight stocks, with the time diversification and the undervalued selection strategy discussed above, reduces the risk that unforeseen events will impact the value of a portfolio.
4. Investing In Growing Industry Segments. One way to reduce the risk that a company will fare poorly is to invest in companies in growing market segments. When demand for a product or service is increasing, on a long term basis a well managed company can position itself to take advantage of the expanding markets.
5. Governmental Trendsÿ Favor Investors. To deal with worldwide competitive markets governments are beginning to realize that they must provide a positive environment for investment capital since it can now easily be transferred around the world. Hence, the discussion of cutting the deficit to lower interest rates, cutting the capital gains tax, privatizing social security, encouraging savings, and increasing the economic growth rate using politically based initiatives.
6. Economic Trends Favor Investors. As inflation declines worldwide, the value of future earnings growth is enhanced - in fact compounded - which makes companies with growth characteristics extremely attractive as long term investments. As long as we are in a non-inflationary environment investments in undervalued growth companies should do well.
OPPORTUNITY COSTS
There is one more risk we should address: the opportunity cost of not investing. Fundamentally the economy is much different today than it was 15 years ago, and the business environment is much more dynamic. Business strategies will need to be redesigned more frequently -with the downside that employees will face more uncertainty, restructurings, divestitures, downsizings, and layoffs than they have traditionally. It is rare for an employee to age to 65 before retiring today,ÿ and it will become more so in the future. In short, relying on stable employment to generate wealth is much riskier than it has been -and will become more so in the future due to governmental trends to globalize business and competition.
The true cost of investing in government tax free bonds, versus investing in the "riskier" market may be increasing -since finding a stable job with a reliable income stream is becoming more difficult in our dynamic global economy.
The fact is the trend toward outsourcing, contract employees, and hiring independent contractors is accelerating. Today, unlike years ago when stable employment, a retirement pension, and social security could be relied upon, these benefits are becoming much more problematical to obtain. In summary, the opportunity cost of not investing for growth is increasing quickly, and dramatically.
CONCLUSION
We are convinced that the information revolution has given the individual investor access to financial data and information on a scale never before imagined - and the ability to use such information to identify some of the most promising undervalued companies in the world." |
