Active stock picking is hard, and for most, it doesn’t work.
November 3, 2021
Stock Picking Doesn’t Work
The first thing to state is every year, S&P Dow Jones Indices does a study on active versus passive management. Last year, they found that after 10 years, 85% of large-cap funds underperformed the S&P 500, and after 15 years, nearly 92 percent are trailing the index.
Active stock picking is hard, and for most, it doesn’t work.
Having said that, people will continue to try, so let’s look into how you might be able to stack the chips a little more in your favour. Firstly, let’s massively over-simplify the world of stock investing by categorising it into two fundamental styles: value and growth.
Usually, value stocks present an opportunity to buy shares below their actual value, and growth stocks exhibit above-average revenue and earnings growth potential, but with little, or no dividend.
While Wall Street likes to neatly categorize stocks into these two groups, the truth is a bit more complicated since some stocks have elements of both value and growth. Nevertheless, there are important differences between growth and value stocks, and many investors prefer one style of investing over the other.
Growth companies prioritise going from small, up-and-coming businesses to leaders in their respective industries as quickly as possible. Early on, these types of companies tend to concentrate on building up their revenue, often at the cost of delaying profitability. After a period of time, growth companies start focusing more on maximizing profits.
As those key financial metrics grow, the perceived value of the company rises in the eyes of growth-minded investors. That can create a positive feedback loop. A rising stock price can boost a company's reputation, helping it win even more business opportunities.
Growth stocks tend to have relatively high valuations as measured by price to earnings ratios. However, they also see faster growth in revenue and income than their peers.
They also tend to be much more volatile and this is often what attracts the new ‘retail traders’. Many of the big growth stock names are run at a loss for quite a long time. You’ll get little or no dividend because they are borrowing huge amounts of money, just to get bigger in their relevant space.
Good examples of this are:
In 2020, Airbnb suffered net losses of $4.6 billion. At the time of writing, its share price is $172. If that isn’t faith in a growth stock then we don’t know what is.
In 2020, Dropbox was a winner from the pandemic and briefly made its first ever profit during lockdown. However, it was short-lived but they still posted their best annual results, reporting a loss of ONLY $256 million.
In 2019, Uber lost $8.5 billion.
To old fashioned value investors, these numbers seem crazy; maybe they are. But these companies also have huge potential growth, and as long as people can see this, their share price will go up, and investors will make money.
The problem with growth stocks like this, is if the plan fails, they have an incredible distance to fall, and no historical earnings to prop them up. If you as the investor don’t ever sell out, your equity value will fall with it.
Value stocks are considered a great deal safer. They are publicly traded companies trading for relatively cheap valuations relative to their earnings.
Value stocks don't have flashy growth characteristics. Companies considered value stocks tend to have steady, predictable business models that generate modest gains in revenue and earnings over time.
Sometimes you can find value stocks with companies that are in decline meaning their stock price is so low that it understates the value of their future profit potential. We saw this happen last year during the pandemic.
Value investors are on the hunt for hidden gems in the market: stocks with low prices but promising prospects. Such investors buy stocks they believe are under-priced, either within a specific industry or the market more broadly, betting the price will rebound once others catch on.
Generally speaking, these stocks have low price-to-earnings ratios (a metric for valuing a company) and high dividend yields (the ratio a company pays in dividends relative to its share price).
The risk? There are several: the price may not appreciate as expected, the dividend may drop, or the sector you chose may suffer. This can be completely unpredictable and unrelated to the reason you chose the stock.
Buffett took an enormous hit with airline stocks during the pandemic, due to unforeseen circumstances. There was nothing he could do.
You might be more inclined to seek value stocks, if you are looking for any of these characteristics within your portfolio:
Good examples of UK value stocks are:
However, just because a company is producing dividends doesn’t always make it a safe bet. Management can use the dividend to placate frustrated investors when the stock isn't moving. (In fact, many companies have been known to do this.)
Therefore, to avoid dividend traps, it's always important to at least consider how management is using the dividend in its corporate strategy. Dividends that are consolation prizes to investors for a lack of growth are almost always bad ideas. In 2008, the dividend yields of many stocks were pushed artificially high due to stock price declines.
For a moment, those dividend yields looked tempting. But as the financial crisis deepened, and profits plunged, many dividend programs were cut altogether. A sudden cut to a dividend program often sends stock shares tumbling, as was the case with so many bank stocks in 2008.
As Larry Swedroe, author of 18 investment books, states: ‘Stock picking has a terrible track record, and it’s getting worse.
It is based on a false notion — that the market is somehow mispricing stocks. The evidence is that the market is highly, though not perfectly, efficient — available information is digested rapidly and reflected in market prices. Stock pickers can’t identify under-priced stocks with any regularity’, especially those without the experience to do so.
The facts are, stock picking is not simple. Many are trying to do it themselves at the moment, but without the relevant knowledge, it is easy to fall into traps and make poor choices.
What we have built at The Portfolio Platform, is a platform that showcases a selection of professional traders, who all have years of experience in the investment world.
It is very hard to pick a good stock, but it is easy to pick a good trader, from a selection of good traders!
We select the traders from all over the world. All you have to do is look at their performance, and choose the ones you like; it’s incredibly simple. Have a look at the track records here, pick the ones you like, add them to your portfolio, and then just let them trade.
Our autotrade technology will take it from there. When they place a trade, you automatically place the same one, making the same return, but with 0% management fee and 0% performance fee.
If you don’t have the time to research, then don’t. If you pick the wrong growth stock at the wrong time, your losses could be significant. Falling into one of the dividend yield traps could also prove costly.
“TPP might just be about to revolutionise investment for the retail market.”
- London Stock Exchange 2020