Thursday, May 18, 2017

Is it that hard to beat the market?

I’ve been thinking about the idea of beating the market on a long-term basis and whether that’s really possible. I laid out some thoughts on that topic below.

There’s a school of thought that suggests the market efficiently prices in all information that’s available to it at any point in time such that it’s theoretically impossible to be able to outperform the market on a long-term basis. Of course the investment results of people like Warren Buffett, Philip Fisher and Peter Lynch obviously suggest otherwise but even a more empirical study of stock price movements suggest that the market is prone to over or under react to information at any point in time. I’ll go into this further, but before that, consider the overall “quality” of the market.

If you think about a broad-based index like the S&P 500 for instance there is obviously varying levels of quality amongst all of the stocks that make up that index. Some of those businesses are clearly on the ascendancy such as Google ,Facebook, Amazon etc. all of which are riding market tailwinds while other businesses such as Ford, U.S. Steel and even Verizon are now on the decline as a result of market changes. Further many of these businesses also have varying levels of profitability, returns on equity and competitive dynamics within their various industries that influence long term returns. Arguably the index itself takes care of better and worst performers through changes in the weighting of these relative components however that doesn’t change the fact that there are still 500 businesses of varying quality within the overall index.


I started my thought process around whether it would be possible to beat the market on a long-term basis by thinking about self-selecting a more reasonable number of businesses (whether that’s 20 or 50 is up for debate) and applying some sort of market-based weighting based on valuation, but having the included businesses be ones that are superior in nature to the overall market based on profitability, returns on equity and favorable market structure.

The second element to long-term outperformance I would argue is then acquiring these businesses at a favorable price. However people may raise the question that if the market is efficient at ingesting all known information at any point in time then how is it theoretically possible to find opportune moments to purchase stock? Of course that begs the question as to whether the market is rational and not prone to overreact or underreact at any point in time. I look at businesses like Amazon which was close to $750 at the beginning of 2017 and which now trades at close to $920 just four months later that’s a swing of more than 20%, or almost $50B in value.

Even more startling was Alibaba a $250B company that moved almost 30% in a month, or close to $75B in September 2015 on no real news.

It’s questionable whether this was a real movement in the underlying value of a business based on the market pricing in new information, or more likely, a case of the market over or underreacting to noise.

In any case, I’ve started to come along to a way of thinking that buying higher quality at  times when there appears to be a some kind of irrational discounting in price on no real news should likely lay the seeds for good outperformance. Of course, this is arguably the basis of what Buffett and Fisher and Lynch have been advocating for extended periods of time.

The last contributor to market outperformance that I would argue is that of smaller or underfollowed businesses. Given that these are generally not tracked or followed by the broader market, these can add some nice heft to overall market returns if discovered early. The play that I think works here is to selectively add to these businesses as they start to get revalued and discovered by the market and start to appreciate in value. Let the market tell you which of these businesses are the relative winners or losers and then add to these on that basis.

Overall, my thought process is that finding a group of overachieving business with a superior quality index that are a subset of the broader S&P500 is a good place to start looking for investment outperformance. Adding to these businesses at times of general market mark downs where there appears to be no real rhyme or reason to explain movements, is likely a good time to see incremental alpha. Finally supplementing this approach with some high quality, underfollowed early stage businesses and adding to these business or increasing their weighting as they become recognized by the market is another good way to get incremental performance for the individual investor.

 
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