Is Stock Picking Dead?

I got some great news yesterday. I found out that the way I'm investing will do very well in the years ahead. How did I find that out? I read that everyone else is giving up on it.

The Wall Street Journal ran an article yesterday titled "'Macro' Forces in Market Confound Stock Pickers." The focus of the article was that macro market forces have so overtaken the stock market that picking individual stocks no longer works.

This wasn't a vague implication of the article, it was quite explicit:

"Stock picking is a dead art form," contends James Bianco of Bianco Research. "Macro themes dominate the market now more than ever."

And it was quite exciting for a stock-picker like me to read.

The market's dancing a lockstep two-step
At times, the market has its ways of grinding down on investors until they cry uncle and agree to do what is probably not in their best interests -- if only to make the pain go away. The past few years have produced exactly that effect for many stock pickers.

As The Journal points out, stocks have been moving in lockstep to a degree that is practically unprecedented:

A widely followed statistic called correlation measures the tendency of investments to move together in a consistent way. Between 2000 and 2006, on average, the correlation of stocks in the S&P 500 was 27%, according to Barclays Capital. ... Between October 2008 and February 2009, at the height of the financial crisis, correlation hit 80%. ... When stocks rallied last year, the figure fell to 40%, then it spiked back over 80% during the European debt crisis, according to Barclays. What has caught many investors off guard is that correlation stayed high over the summer. In mid-August, correlation was 74%. In recent weeks, it has drifted down to 66%.

When all stocks move together like that it means that stock pickers don't get any extra juice for the time and effort that they put in trying to pick out the very best issues and instead are stuck with the returns of some broader group of stocks that their individual picks are a part of.

For stock-picking mutual fund managers, the inability to generate excess returns through stock selection can be more than annoying -- it can mean chronic underperformance that leads to massive fund outflows. And it should be no surprise that job insecurity is a great motivator for a change in investment strategy.

Oh the absurdity!
I wouldn't think that I'd ever have to review why it doesn't make sense for all stocks to move in lockstep, but maybe a refresher isn't such a bad idea.

Here's a handful of stocks from the S&P 500 index:

Company

Trailing Price-to-Earnings Ratio

Return on Equity

Net Income Margin

Expected Long-Term Growth Rate

Visa (NYSE: V  )

19.5

11.4%

34.6%

19.7%

Alcoa (NYSE: AA  )

NM

(1.3%)

(2.0%)

1.5%

EMC (NYSE: EMC  )

30.7

9.8%

9.6%

14.8%

Emerson Electric (NYSE: EMR  )

20.9

22.0%

9.1%

13.8%

ConocoPhillips (NYSE: COP  )

8.9

15.2%

5.9%

13.1%

Source: Capital IQ, a division of Standard & Poor's.

If we assume that stocks will continue to move in lockstep, following the path of the rest of the index and climbing and diving based wholly on macro market events, then the numbers in the table above have very little meaning. And to think that profitability levels, valuation multiples, and expected growth rates of individual stocks will have little predictive power over how those stocks will perform sounds absolutely inane to me.

But the numbers are really only the beginning of it. The businesses included in the list above also vary considerably and their prospects for future profit growth -- or contraction -- depend on very different drivers.

Visa will thrive on the world's continued shift from paper to digital currency, while Alcoa will see its profits swing back and forth based on demand and pricing in the aluminum market. Emerson Electric's future will depend heavily on growth abroad since more than 50% of its revenue comes from outside the U.S. shores. For obvious reasons, ConocoPhillips will depend heavily on oil prices, while the performance of VMware (NYSE: VMW  ) will significantly affect the value of EMC because of EMC's hefty ownership position in its former subsidiary.

When these stocks all move in time with the rest of the S&P 500, it implies that these very significant differences are meaningless. Shall I say it again? Inane.

Why this is great news
The fact that it makes no sense for the stocks of companies with different businesses, profitability levels, prospects, and valuations to move in lockstep means that great opportunities could be created.

The reason is that the longer the market as a whole doesn't take into account the change in things like profits or profit outlook for individual companies when determining prices, the more likely it becomes that valuations of individual companies will get out of whack.

As I mentioned above, this can mean death for mutual fund managers when it lasts for any meaningful length of time. But when it comes to the advantages that individual investors have over institutional investors, the ability to be patient is near -- if not at -- the top. And if other investors are truly starting to ignore the differences between individual stocks that patience -- along with the diligence to find those mispriced stocks -- could pay off in a big way in the years to come.

Of course while pretty much any stock could fall into no-man's land and be allowed to drop into undervalued territory, I continue to think that investors will often be better off focusing on dividend-paying stocks.

Consider a dividend aristocrat like Sherwin-Williams (NYSE: SHW  ) . Over the past five years, it has averaged 14% annual dividend growth, and with expected annual earnings growth of 9% and a payout ratio of just 35%, it certainly has room to continue to grow its payout. What this means is that if a stock like Sherwin-Williams were ignored by the market, the patience issue becomes less academic since you'd be collecting a healthy, growing stream of cash payouts.

Of course, I'm a die-hard stock picker myself, so I'm highly biased on the subject. Think I'm off base and the art of stock picking is a dusty relic? Head down to the comments section and sound off.

Still interested in picking stocks? These five could be ripe for the picking.

VMware is a Motley Fool Rule Breakers recommendation. Sherwin-Williams is a Motley Fool Stock Advisor pick. Emerson Electric is a Motley Fool Income Investor choice. Try any of our Foolish newsletter services free for 30 days.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookies were harmed in the making of this article.


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  • Report this Comment On September 28, 2010, at 3:51 PM, BillyTG wrote:

    You're both right.

    Bianco's statement "Macro themes dominate the market now more than ever" is exactly right in my opinion.

    Anyone that uses traditional value or buy-and-hold (or pretty much any other style, for that matter) is in for a rude awakening if he doesn't understand the macro forces in play.

    Ultimately, I think one of the best ways to invest is to understand the macro trends to focus in on the promising sectors, then look for the best values in those sectors' stocks.

    For instance, precious metals have been and still are poised for big gains, so look for the best precious metals individual stocks.

  • Report this Comment On September 28, 2010, at 4:35 PM, Clint35 wrote:

    Good article Matt. I don't think stock picking is dead it's just not very common right now. A lot of people are still scared to buy individual stocks. But personally I think paying any attention to macro or micro indications of anything is a waste of time. You might as well try and figure out who's going to win the world series when it's only April. People are making it too hard. All you have to do is buy good companies at good prices. If the price goes down buy more and get an even better deal. That's especially true of stocks that pay a good dividend like COP. But a lot of people seem to think if the price goes down it's some terrible event and they have to sell.

  • Report this Comment On September 28, 2010, at 4:48 PM, MellowGuy1 wrote:

    I don't see a good alternative to stock picking.

    Stock indexes bundle questionable stocks with the good stocks.

    Bonds pay minimal interest.

    I disagree with your emphasis on paying dividends because that reduces the companies ability to grow in terms of sales, debt, or profits.

  • Report this Comment On September 28, 2010, at 4:48 PM, rd80 wrote:

    Good article Matt.

    "Stock picking is a dead art form," contends James Bianco

    Thousands of CAPS players beg to differ.

    Mr. Bianco should try explaining his position to anyone who bought Freddie Mac or Fannie Mae a year ago. Anyone who bought EBIX about the same time could give him an argument from the other side of the outperform/underperform line.

    Disclosure: Long EBIX

  • Report this Comment On September 28, 2010, at 4:54 PM, daveandrae wrote:

    hmmm...

    My Portfolio-

    Asset Allocation-

    100% equity- 0% bonds.

    Total return over the last 12 months-

    McDonalds - 34.89%

    Harley Davidson - 25.69%

    Pfizer - 9.49%

    Dow Chemical - 7.87%

    General Electric - 0.71%

    Turnover ratio - 0%

    Total, Aggregate, Return on invested Capital

    15.73%

    S&p 500

    11.56%

    Is stock picking dead? Of course not.

    Thomas Edmonds

  • Report this Comment On September 28, 2010, at 4:56 PM, baldheadeddork wrote:

    I don't think stock picking is dead, but I think SHW is a really bad example to use if you want to talk about the opportunities in a macro-focused market. I think it's a good case study of macro forces creating a lot of risk.

    The dividend has increased consistently, but even with that the yield is just 1.9% because the share price has been on a tear for the last decade. Share price is up 270% in the last ten years, and the dividend is up 150%. That's hugely impressive when you look at the performance of the S&P over the same period.

    My problem is that the share price has continued to rise at a really healthy clip even as their sector (home improvement and construction) imploded. Since 2007 their operating and net income have fallen by a third, shareholder equity is down 17%, and the amount of long-term debt has nearly tripled. All as you would expect given the decline in residential and commercial construction. Yet the share price is up 30% in that period. P/E is now 20% higher than it's closest competitors, and it's running 20% above the average for SHW over the last five years.

    I don't think you'd have that kind of sustained growth in the market we've had for the last couple of years if there weren't some macro forces working in its favor. There has to be something about SHW that some people who can move a stock price like a lot. But it's not showing up on their balance sheets or their forecasts.

    I think that creates a huge risk to get crushed if the money that's driven up the share price goes elsewhere, or (at best) you're left holding a stock with a stagnant share price and a yield that runs a couple points behind inflation. Outside of another bubble market I can't see how SHW sustains this growth for the next five years.

    The trick, of course, is to find a company that's in the same spot Sherwin Williams was ten years ago. My top pick is Ford. I think it's the strongest automaker in the world, they're making a lot of money even at very low sales levels, and when demand for new cars returns to normal levels they're going to blow the roof off their earnings. For the cherry on top, this is an industry and a company that historically pays a dividend. There's enough upside potential on the stock to support it solely on a value buy, and if the dividend returns in a couple of years you're going to pull a yield you'll tell your grandchildren about.

  • Report this Comment On September 28, 2010, at 5:40 PM, goalie37 wrote:

    It's dead? I wish somebody had told me. I've been kicking the market's butt by being a stock picker. I better stop soon and join the herd!

  • Report this Comment On September 28, 2010, at 5:45 PM, gio14 wrote:

    Nice article, I really believe we'll be kicking our selves for not looking at some of these individual stocks that are truly on sale right now, 10yrs from now i smell big profits but it's a hole different story if your outlooks isn't that long, things are just too unstable right now, I'm seeing a rut for the next few years where much of nothing happens.

  • Report this Comment On September 28, 2010, at 6:16 PM, TMFKopp wrote:

    @baldheadeddork

    You make some great points on SHW and I'm not going to argue with you. Here's what I said in the article:

    "What this means is that if a stock like Sherwin-Williams were ignored by the market, the patience issue becomes less academic since you'd be collecting a healthy, growing stream of cash payouts."

    In other words, SHW is an example of a reliable dividend payer/grower and _if_ it were forgotten by the market and its valuation got out of whack, you'd have that reliable/growing dividend payment to keep you warm at night along with the instinct that the market would come back to its senses at some point.

    To your point, perhaps my example should have been a stock that both has that aristocratic dividend component and is attractive right now -- something more like CLX for instance (http://www.fool.com/investing/dividends-income/2010/09/03/ho....

    But SHW is one that's worth having on the radar in case the value prop does get better -- it's one of those companies that I'd like to own if the price was right.

    Thanks for reading and for the comment.

    Matt

  • Report this Comment On September 28, 2010, at 6:25 PM, TMFKopp wrote:

    @MellowGuy1

    "I disagree with your emphasis on paying dividends because that reduces the companies ability to grow in terms of sales, debt, or profits."

    Well I disagree with your disagreement :)

    Seriously though, the best dividend-paying companies are those that aren't sacrificing real, worthwhile growth opportunities in favor of paying shareholders. When you've got the right company that's managing its capital properly then it's a decision between the returns that can be had by investing in growth and the implied cost of equity. Smart management won't forgo great growth opportunities to pay larger dividends, nor will they throw money at low-returns opportunities or bad acquisitions just to say that the company is still growing.

    The ability to pick stocks / companies is a major part of Warren Buffett's success, but an often overlooked aspect of his success has been his ability to allocate Berkshire's capital. He makes sure that every penny in cash produced by the Berkshire companies is being put towards the most lucrative opportunities -- and that's a recipe for success.

    We're not going to want most corporate managers to try and be like Buffett and turn their companies in to diversified holding companies when they run out of good internal investment opportunities. So instead, we're better off having them give the capital back to us so that we can reallocate it.

    Matt

  • Report this Comment On September 28, 2010, at 6:32 PM, richie54 wrote:

    Good article, Matt. Plenty of Sherwin-Williams types out there if you know how and where to find them. Us stock pickers will continue to smile while many others run around like Chicken Little.

  • Report this Comment On September 28, 2010, at 7:33 PM, BillyTG wrote:

    Y'all be careful bashing any particular investing techniques. If there's one thing I've learned, it's BUY LOW, SELL HIGH. Works with individual stocks, sectors, shorting (in chronological reverse), puts, calls, LEAPs, day trades, commodities, real estate, and everything else.

    Investing among the general public has become much more sophisticated over the past decade or two. Motley Fool used to push their "Famous Four" or whatever silly name they gave the top 4 DOW dividend yielding companies. They used to bash shorting and options of any kind. Today, we see MF services for shorting, for trading options.

    Want an example of a successful investor who doesn't spend much time on individual stocks? Jim Rogers. Read his book on traveling the world. He finds countries he likes and buys ALL the stocks offered on that country's exchange, or all the stocks in a given sector for bigger exchanges. He's making macro-level bets.

    Want an example of an investor who knows how to do both, that is analyzing macro trends and then laser-focusing on the very best investments within that trend? Michael Burry, the guy who figured out the sub-prime mortgage disaster before anybody else. This is a superior investment methodology in my opinion, but who has the ability to do it? Not many. Burry by the way is now investing in agricultural land and gold and I'm sure he's finding the land and gold deals most likely to appreciate compared to the risks involved.

    Motley Fool seems to propagate this belief that anybody can become a miniature Warren Buffett. It;s complete nonsense. As the general public's investing sophistication has grown, so too has that of hedge funds, investment banks, and other professionals. These guys move huge amounts of money using quantitative methods run by PhDs from MIT. Us small time investors are at their mercy. Warren Buffett, too, gets insider treatment and special deals that nobody else can.

    Hey, I believe in stock picking and do just fine in CAPS and my real portfolio. I also believe in value investing. I also believe that anyone who bashes a particular investing style probably has a lot to learn about investing. Be careful about thinking any one style is the holy grail of investing, and be careful about believing that you are a mini Warren B.

  • Report this Comment On September 28, 2010, at 7:55 PM, TMFKopp wrote:

    @BillyTG

    I'm not sure what you're referring to specifically, but the article and the comments have mostly dealt with the assertion that stock picking is no longer useful. Maybe I missed it, but I don't think anyone said that investing based on macro factors is a bad idea. Instead we've been focusing on the fact that it's silly to say that macro factors are all that matter and spending time to find the best companies is a worthless endeavor.

    Matt

  • Report this Comment On September 28, 2010, at 8:04 PM, johngo55 wrote:

    I have run two side x side portfoilios for the past 1 yr. Portfolio 1 is a passive group of utilities and consumer staple cos. Portfolio 2 has been a technical trading portfolio. Dividends included, the passive group of hand picked stocks has returned 16.6%. The heavily traded, technical portfolio, based on sites advice, and trend analysis has returned 1%. backtesting these portfolios is next to impossible for me, but I would submit that well chosen, simple to understand companies with a consistent dividend will do most investors proud while the trading accounts, although fun, will be relegated to christmas cocktail bravado.

  • Report this Comment On September 28, 2010, at 8:47 PM, Lockett03 wrote:

    2009 earnings on stocks I picked using my favorite technicals (rules) 29.8%..YTD 9.8% and moving upward..I love that people depend on the media's global economic outlook to fuel their buying decisions (or lack there of).. more for me I guess. Party on Garth!

  • Report this Comment On September 28, 2010, at 8:57 PM, BillyTG wrote:

    Matt, I must have had a soapbox rant burning within!

    It happens sometimes!

    @Lockett03, what's the media's global outlook right now? Serious question! I can't figure out the media.

  • Report this Comment On September 28, 2010, at 9:05 PM, Lockett03 wrote:

    @ BillyTG, Convoluted..lol which makes people confused hence the "lack there of" as noted; which is why I take what they have to say with a grain of salt.

  • Report this Comment On September 28, 2010, at 10:02 PM, aleax wrote:

    @BillyTg, "they used to bash shorting"? When? Must have been BEFORE their successful book "The Motley Fool Investment Guide" in '96, because in that book (which also heavily touts the Foolish Four and some other variants on what's now known as "Small Dogs of the Dow") they put shorting on a pedestal and devote a whole chapter to explaining and praising it. All "Dogs of the Dow" variants have long stopped working well (cfr the website http://www.dogsofthedow.com/dogyrs.htm for the 15-years column, i.e. exactly since the book was published: yearly annualized, "Small Dogs of the Dow" +8.6%, plain "Dogs of the Dow" +9.0%, Vanguard Index 500 +10.3% -- though the Fools in the book dare dump on Bogle, $10k invested 15 years ago per the various formulas would now be over 43.5K with HIS fund, vs 26K with "Small Dogs"...!-).

    You're right about options -- I guess at the time commissions were just too high to make conservative options strategies (like buy-write) worthwhile for the small investor?-) (To this day, while great books w/titles such as "Options Trading for the Conservative Investor" abound, options still have a strong connotation of speculation to most people... kind of like common stock had in the 1940's, I guess!-).

  • Report this Comment On September 28, 2010, at 11:05 PM, BillyTG wrote:

    @aleax, I was wrong about the shorting.

    Thanks for talking about the Foolish Four. The name was on the tip of my tongue, but I couldn't quite get it out.

  • Report this Comment On September 28, 2010, at 11:43 PM, xserver wrote:

    Well now that does it. I'm just going to have to cancel all my MF subscriptions, sell my stocks and put the money in an index fund. Boy do I feel stupid now.

  • Report this Comment On September 29, 2010, at 1:17 AM, TMFKopp wrote:

    @BillyTG

    "Matt, I must have had a soapbox rant burning within!

    It happens sometimes!"

    Yes, it does happen sometimes :)

    Just wanted to make sure I wasn't missing something.

    @xserver

    No kidding! Sheesh, you totally should have known better...

    Matt

  • Report this Comment On September 29, 2010, at 9:17 AM, opedbyme wrote:

    On the contrary I think stock pickers are a going industry. How to invest ones saving and have it grow is very serious business. As more and more folks get into equities and realize the many mays to analysis data both technical and fundamentals they will come to the realization that having a financial adviser is a must. Financial management companies are going to flourish in the near and long term future. Couch potato investors like me will eventually come to realize that we need professional managers to handle our hard earned cash flow.

  • Report this Comment On September 29, 2010, at 10:24 AM, Brent2223 wrote:

    I find this environment to be ideal for stock picking. If we agree that all stocks end up moving with the market it is very easy to find stocks that have underperformed and wait for them to catch up. Even better, watch for underperforming sectors and find the market leaders - it's not rocket science that alot of sectors have cyclical cycles, but not alot of people seem to move on this.

  • Report this Comment On September 29, 2010, at 4:33 PM, shaileshnita wrote:

    This is an excellent piece of work; for academics as well as an average Joe-the-plumber like me. I always wondered about why stocks move in lockstep. This has to do with investor psychology. The writer's suggestion that one could cash on this element of investor psychology, in my opinion, is a breakthrough. Thank you.

  • Report this Comment On October 04, 2010, at 1:00 PM, thisislabor wrote:

    I'm a finance major at ASU - stocks and markets around the world have the highest correlation when they fall but, the lowest correlation when the rise.

    We all sink together but the good ones will come back up to the top.

    Just sayin' what the research i'm learning has been supporting.

    (it also says you can't beat the market *shrugs* so go figure)

  • Report this Comment On October 04, 2010, at 1:04 PM, thisislabor wrote:

    er... it technically says you can't beat alpha. (which is slightly different then beating the market - you can but you have to take on excess risk to do it)

  • Report this Comment On October 27, 2010, at 9:15 PM, FlorisHJ wrote:

    One technique not getting much attention here: differential investing. If you think company A will outperform B, you can short B and use the proceeds to buy A. Your profit on the deal will mostly depend on their relative performance, not the absolute one. Thus, if the entire market drops 20% your trade will still make money if B falls faster than A. Of course instead of shorting you can use options to achieve the same thing. And instead of stocks you can use entire industries, countries, or sectors, using appropriate ETFs. Example: over the long term the ratio of gold price to Dow oscillates. If you short the Dow and buy gold when the ratio is over 20 and unwind the trade when it drops below 10 you stand to make good money. You can do the same thing in reverse when the ratio is heading the other way. Correlation can be your friend!

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