Why Today Is a Great Time to Be a Stock Picker

Ah, fall is in the air again. That means it's just about time for my family and me to pile into our Jeep, drive out to the Virginia countryside, and pick apples.

One thing that always puzzled me about apple farms, however, is they always have pre-packaged bags of apples available for sale. Half the fun of battling D.C. traffic and heading out to the countryside is to spend time in the fresh air, hand-selecting the best apples in the orchard. What's more, it's cheaper to pick your own apples.

Call me crazy, but driving a hundred miles to pick up a bag of overpriced apples of uncertain quality seems a tad lazy to me.

When you think about it, buying the pre-packaged apples instead of picking your own is a lot like buying ETFs instead of buying individual stocks. Rather than taking the time to seek the very best stocks in the market, it's much easier -- and costlier, in many cases -- to buy a pre-packaged bag of stocks that fit a certain theme and call yourself diversified.

Yes, now you see why my wife dreads taking me anywhere; I tend to draw investing parallels to everything I see.

Admittedly, I've owned and recommended ETFs in the past, but their purpose has been to fill in diversification cracks in a portfolio rather than to serve as the foundation of the portfolio. So ETFs do have their place, but investors have become so ETF-crazy that their lazy money may have created the perfect scenario for stock-pickers to snatch up the best stocks in the market.

A few rotten apples
The emergence of the ETF in the stock market has been incredible. In September, for example, U.S.-listed ETF assets hit an all time high of $906 billion, more than tripling from a level of $296 billion in December 2005.

And as my Foolish colleague, Morgan Housel, reported in August stock market ETF assets increased by more than $250 billion while they withdrew $9 billion out of equity mutual funds from February 2009 to June 2010.

Curious, no? It seems that investors may not necessarily be bearish on stocks, per se, but bearish on stock picking. Instead of letting a mutual fund manager use his or her skills to find the best stocks in the market, investors appear to prefer their investments to be indexed in an ETF.

This behavior is having repercussions in the market. Barclays Capital, for instance, noted that this massive inflow of lazy money into indexed ETFs has led to a higher correlation of both good and bad assets, saying that "Since 2005, equity correlation has had a close relationship with the increased ETF volumes relative to the volumes in underlying stocks."

Put another way, the increasing prominence of ETFs may have led to a mispricing of assets and left good stocks cheap and bad stocks expensive. This, in short, is a stock-picker's paradise.

Rising tide
When PotashCorp rejected BHP Billiton's unsolicited takeover bid on August 17, Potash shares jumped 28% as investors cheered management's claims that BHP's offer grossly undervalued the company. This excitement led agriculture-themed Market Vectors Agribusiness (MOO) to gain 5% while the ETF's volume nearly tripled, even though Potash made up only 8% of the portfolio holdings.

On the same day, look at what happened to the other top holdings in the ETF such as Monsanto, Deere, and Syngenta AG:

Company

Weight in ETF as of Aug. 16

Price Change

Daily Volume Change

Monsanto

8.2%

2.5%

85%

Deere

8.2%

2.5%

67%

Syngenta AG

7.1%

3.1%

73%

Data provided by Yahoo! Finance.

It's true that good news for one company in a sector can lift the rest of the sector, but this is a bit extreme given that Monsanto, Deere, and Syngenta have no meaningful direct exposure to fertilizer. Monsanto and Syngenta both primarily deal in production-enhancing chemicals like herbicides, pesticides, and seed care while Deere manufactures farming equipment. Indeed, there was no other remarkable news on August 17 for any of these companies that would have explained the jump in share price and trading volume.

Bringing my apple analogy full-circle now, shares of Apple (Nasdaq: AAPL  ) currently make up 20.5% of the PowerShares QQQ (Nasdaq: QQQQ  ) ETF -- the second-most heavily traded ETF behind SPDR S&P 500 (NYSE: SPY  ) -- while other strong companies like Intuitive Surgical (Nasdaq: ISRG  ) , Costco Wholesale (Nasdaq: COST  ) , and Bed Bath & Beyond (Nasdaq: BBBY  ) play only a supporting role in the ETF with less than 1% of the assets each. In fact, the next highest weighting behind Apple is Qualcomm (Nasdaq: QCOM  ) , at 4.64% of fund assets. This skew toward Apple is made possible because of the Nasdaq 100 index's "modified" capitalization-weighted methodology, which essentially means that it'll be weighted however Nasdaq sees fit.

To illustrate how this setup can also skew the valuations of other QQQ holdings, in September alone, the ETF attracted $4.3 billion in new assets. If you do the math that means the capital was likely distributed among the aforementioned stocks as such:

Company

Current Index Weight

September Inflow*

PEG Ratio

Apple

20.51%

$882 million

1.08

Qualcomm

4.64%

$200 million

1.12

Bed Bath & Beyond

0.82%

$35 million

1.19

Costco Wholesale

0.78%

$34 million

1.51

Intuitive Surgical

0.57%

$25 million

1.30

Approximate, based on current ETF weights; Data provided by Yahoo! Finance and Invesco PowerShares.

For those of you who aren't familiar with the PEG ratio, it simply takes the company's price-to-earnings ratio and divides it by the estimated earnings growth rate. The lower the PEG ratio, the more undervalued the stock.

This is indeed a back-of-the envelope valuation method, but it shows clearly that while Apple may be a reasonable destination for capital, it may not be worth four times more capital than Qualcomm, 25 times more than Bed Bath & Beyond and Costco, and 35 times more than Intuitive Surgical.

What to do
The ETF madness has brought more lazy money into the stock market, which has led to a mis-pricing of assets and left some great companies undervalued. Put simply, that means today is a great time to be a stock picker if you know how to identify those mis-pricings.

If you'd like some help building a portfolio of hand-selected companies rather than follow the herd into ETFs, consider our Million Dollar Portfolio service, which builds portfolios of the best of the best Motley Fool newsletter stock recommendations. To learn more about Million Dollar Portfolio, simply click here and enter your email address in the box.

Fool analyst Todd Wenning does not own shares of any company mentioned. Costco Wholesale is a Motley Fool Inside Value selection. Monsanto is a former Motley Fool Inside Value selection. Apple, Bed Bath & Beyond, and Costco Wholesale are Motley Fool Stock Advisor recommendations. Syngenta AG is a Motley Fool Global Gains pick. Intuitive Surgical is a Motley Fool Rule Breakers selection. Motley Fool Options has recommended a synthetic long position on Monsanto. The Fool owns shares of Apple, Qualcomm, and Costco Wholesale.

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. The Motley Fool has a disclosure policy.


Read/Post Comments (11) | Recommend This Article (48)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 15, 2010, at 5:23 PM, PositiveMojo wrote:

    Nice article and thanks for the insight into the PEG ratio. Just one more tool to help stay away from those rotten apples!

  • Report this Comment On October 15, 2010, at 8:48 PM, Quick2learn wrote:

    Nice analogy about the apples, but the aged, handicapped and disabled will be buying the bagged apples and not climbing into the orchards.

  • Report this Comment On October 16, 2010, at 1:11 PM, qwer2003 wrote:

    thnx mate, wht is the prediciton? will the stock market go up?

  • Report this Comment On October 16, 2010, at 11:39 PM, BillyTG wrote:

    TMFPhila,

    Is it really a great time to be a stockpicker?

    Some think it's the worst time EVER, mainly because the Fed is hugely manipulating the market, throwing all analysis principles out the window.

    http://www.zerohedge.com/article/barclays-quant-commentary-w...

    http://www.kingworldnews.com/kingworldnews/Broadcast/Entries...

  • Report this Comment On October 17, 2010, at 10:41 AM, bucheron wrote:

    BillyTG, he's not looking at the big market, because he does'nt need to, he's looking at underpriced companies thats all.

  • Report this Comment On October 17, 2010, at 11:28 AM, BillyTG wrote:

    Why wouldn't anyone look at the big market? To do otherwise makes some big assumptions, one being that the market place is not being highly manipulated right now and has signs of extreme political instability.

    No offense to believers of the system, but this article sounds like Motley Fool 1990s mantra: "The market will always go up...the US is the greatest, most innovative people in history...find undervalued companies and hold forever." Today, that sounds naive. Even if we are arguably the most innovative people ever, the system is rigged against the people, so in the end we are at the mercy of the Fed's banking cartel...and there are serious problems there right now.

  • Report this Comment On October 17, 2010, at 9:04 PM, AirForceFool wrote:

    I wish everyone that was capable of picking their own apples were capable of picking their own stock... there are fools out there that don't have 2 hours a week to do research... admittedly, they may have their priorities out of synch... some Fools spend 20 hours a week and still don't know as much as they'd like... (looking in the mirror with hand raised)... there are a lot of reasons people don't pick stocks:

    1. Unable to comprehend the stock market (there are a lot of folks in this category).

    2. Unwiling to take the time to learn (these folks I don't have to much sympathy for).

    3. Those that think they're to busy (kids, work, etc), and prefer to let someone manage their money, or sink funds into indexs and ETFs.

    4. Folks that have been burned by the stock market, and are afraid, prefering safer investments... not really comprehending the varying risk associated with say small cap or emerging market stocks...

    Bottom line is that if I lined up a hundred family members and friends the breakdown would look like: 70 don't make enough to save, let alone invest... 25 do, but would rather have fun now and don't want to be bothered... they're going boating this weekend... the last 5 have the money or will have the money, and want me to invest it for them... let them know how they're doing from time to time.

    Chris

  • Report this Comment On October 18, 2010, at 12:45 PM, henryking54 wrote:

    Stock picking is a losing proposition. The only reason Todd Wenning is badmouthing index funds is because newsletter subscriptions based on stock picking pay his salary. Rather than listening to somebody with a series conflict of interest, listen to the words of unconflicted William Bernstein:

    "A portfolio of 'carefully chosen' equities could easily wind up with none of the best-performing stocks in the market - and thus produce flat or negative returns over many years. Missing out on even a handful of superstocks can leave you short of your target."

    http://money.cnn.com/2009/05/09/magazines/moneymag/stock-str...

  • Report this Comment On October 18, 2010, at 3:26 PM, PeyDaFool wrote:

    henryking54,

    You and William Bernstein are indeed correct that picking individual stocks could result in losses or flat returns over a period of time. However, at the same time, picking individual stocks could result in huge gains and help us to seek alpha and beat the market, too.

    This presents a great "have your cake and eat it too" analogy, since picking ETFs are great for mitigating risk, but they're not so great for securing market shattering returns.

    I agree with Warren Buffett in that the majority of individuals would likely benefit from buying ETFs instead of stocks. In fact, on a long time horizon, I would probably be better off with ETFs too, but since I'm using "fun" money for picking my stocks and I greatly enjoy this hobby, I appreciate Todd's articles that help highlight undervalued companies and investments. I use ETFs and mutual funds for retirement and I challenge myself to see if I can beat the returns from these retirement investments with my own stock picking abilities.

    Thanks for the article, Todd. Fool on!

  • Report this Comment On October 23, 2010, at 11:40 PM, oviedopeo wrote:

    So this just an add for the million dollar portfolio? So you told us the about PEG. Most people know that. (If they don't know about PEG they probably don't have the capital/were-withall to pay thoses fees). Instead of just a long advertisement what about some real information concerning stocks that have a good PEG value and are not going to burn in the next few weeks?

  • Report this Comment On November 17, 2010, at 3:03 PM, Notfooled1 wrote:

    Please note that the Million Dollar Portfolio is NOT Fool Money although the investors are likely fools. It is investor money from which the MOTLEY FOOLS take a hefty fee for mediocre performance at best. Let's see an audited performance of FOOL stock selections. You may be surprised at how poorly they have done.

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