It seems straightforward for a stock picker to beat the overall market. Simply buy better quality stocks, avoid owning bad quality companies, and handily beat the market. It really can't be that hard, can it?
So you pick a strategy such as "deep value" (think Warren Buffett) or technology stocks with surging momentum (think ARK ETFs). This can work for decades as Buffet has proven or over a short two-year period such as ARK's success (before ARK dropped +50% in 2022). You try to understand their success. But it is difficult to ascertain why profits occurred....was there a skill or simply fortunate timing?
Investment managers and individual stock selectors have a sound rationale for implementing their strategies. There is any number of compelling and logical thoughts.
"I will buy growth stocks at a reasonable price" (GARP)
" My team focuses on momentum, we catch the winners " (MO)
"Buy stocks below intrinsic value, so there is a large margin of safety" (note: in my view, there is no such thing as intrinsic value....it is just a minimum price an analyst calculates the stock is worth )
From the hundreds of strategies, I think it boils down to three core methods for trying to make money.
1. Try and massively outperform the major indexes in a Bull Market BUT suffer the consequences of holding volatile stocks in a down market. You hope that the net result beats the market. This a very risky strategy as numerous high fliers are down 50% this year and now need a 100% return to regain the losses.
Take the example of ARK Innovation ETF versus the QQQ (NASDAQ ETF). ARK gained over 210% before falling to a negative three-year return. The slower-paced QQQ also pulled back substantially but continues to hold a positive three-year return.
2. Try and eke out a small excess return each year and marginally outperform over a long period. Trust that your stock-picking ability offers you an advantage that will compound over time. I would place Warren Buffet in this category. His company, Berkshire Hathaway has had the advantage of using insurance reserves to increase its investable capital (adjusting for the use of these extra funds - Berkshire returns are similar to owning the S&P 500 on margin). Marginal annual outperformance is a viable strategy if investors can identify a manager with a rare ability to show consistency in stock selection.
3. Try and lose less money in Bear markets. If the stock market drops 25% and your strategy drops 15%...you have a 10% advantage in future return when the market regains its footing. This is my preferred strategy. This strategy is less stressful when you experience inevitable setbacks. You can take some comfort in knowing that you are down less than the market and may bounce back quicker.
For the past 20 years, I have been experimenting with stock strategies that might provide an edge. Combining strengths from each of the three identified strategies. Success is difficult! Big winning streaks, followed by painful losses.
The world's best traders are reported to make profitable trades approximately 60% of the time. This may seem like a low success rate, but it depends on how much money you make on the winning trades and how much you lose on the balance. The investment industry refers to this factor as a type of "positive skew".
You can see positive skew clearly in the Exponential Disruptors strategy. This beta strategy was self-designed and initiated in my own portfolio in September 2016 and ran until March 2020. Each of the vertical bars indicates an individual stock realized profit or loss on their respective sale.
Positions sold below the 0% horizontal line were sold at losses as high as 30%. Shopify, positioned at the far right of the graph, was the most profitable trade returning 180%
The majority of the trades were profitable as the skew was strongly dominating the right side of the graph. Profitable trades were in the majority and the winning positions had significantly larger percentage gains than the losing trades. The difficulty with the strategy was that it was very technology focused. The portfolio was made up of the fastest-growing companies in the global economy (Tesla, Shopify, Netflix, Alibaba etc.,).
This Exponential Disruptor strategy was designed to limit losses by selling holdings that declined by 15% to 20% ( either from the initial cost base or from their most recent high price). The difficulty with finding comfort in the strategy is that these fast-growing companies are interconnected in investors' minds, and can simultaneously disappoint. It might be missed earnings, loss of a contract, or perhaps poor forward guidance. When high flyers stub their toes it is an immediate and painful experience. Any slowdown in future prospects could cause the stock to drop over 20% from the prior day.
The strategy produced a very satisfying return but was too volatile for my personal risk tolerance. I learned a great deal from the beta strategy and am currently in the process of designing and implementing a new strategy.
Guiding Principles
Increase the diversity of the portfolio. Avoid sector concentration that created excessive volatility in the Exponential Disruptor portfolio. Allocate the portfolio by equal weight to 20 differentiated businesses.
Continue to be disciplined. Establish a set of rules for what stocks qualify for the portfolio (math based, but subjective).
Continue to have pre-established profit-taking targets so that no stock dominates the portfolio.
Focus the new portfolio on companies with strong earnings and fortress balance sheets, rather than purely future growth expectations
Continue to have pre-established sell prices for stocks based on their cost base (for stocks that drop immediately from the purchase price) or when a stock drops from the highest recent trading price (important as you want to avoid, if possible, giving back all your profits)
Few have much success with timing entries and exits. So the strategy will not be based on clairvoyance, but rather on risk avoidance and a careful set of rules to limit human emotion on difficult days.
In my next analysis, I will detail the criteria for what stocks qualify for the MortonIR Strategy. See if I can solve some of the difficulties of the Stock Pickers Dilemma.
Merry Christmas and best wishes for the New Year.
Tim
Thoughts, agreement/disagreement? email me at tim@mortonir.com
Tim Morton, CFA is a retired portfolio manager with 45 years of experience working with private clients and is the editor of mortonir.com and a contributor to Barron's.