How to Beat the Market

In this podcast, Motley Fool host Ricky Mulvey and Motley Fool Live program manager Anand Chokkavelu got together to explore different camps within the world of investing, from short-term traders to buy-and-hold-for-lifers, value hunters to growth gurus.

They discuss:

• Distinguishing between luck and skill when evaluating high-profile investors.
• The power of being a smart contrarian.
• Which traits make for a truly successful market-beating strategy.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on August 05, 2023.

Ricky Mulvey: If you find what a narrative is in the market versus what you think the narrative actually is for a company and where there might be more nuance and complexity, I think that's where maybe more of the modern value investors reside. Finding the variant perspective.

Mary Long: I'm Mary Long and that's Motley Fool Money producer, Ricky Mulvey. Ricky caught up with our very own Anand Chokkavelu to take a look at different investing strategies and determine if there really is one best way to beat the market. They discuss following the footsteps of investing grades, knowing when to not try something at home, and what past patterns can and can't tell us about future returns.

Ricky Mulvey: We can't guarantee that you'll beat the market, but we can tell you about some folks who have. Joining us now is Anand Chokkavelu. Anand, good to see on this weekend.

Anand Chokkavelu: Great to see you, Ricky.

Ricky Mulvey: The hardest part about beating the market or declaring that someone has beaten the market is seeing if it's like luck versus skill.

Anand Chokkavelu: Yes, very hard to separate the two. That's why you have all these comparisons to monkeys throwing darts and flipping coins. But we do know two things. The longer someone beats the market, the more likely it skill, and then the more people who beat the market using similar strategies, the more likely it's skill.

Ricky Mulvey: Fair enough. But what do you think's the timeline? If someone has beaten the market over x time period, you're ready to hand them a Sasha and a crown saying congrats, you've done it.

Anand Chokkavelu: For me, there's no magical timeline for this. Honestly, someone could be lucky their whole investing life. But I'm a heck of a lot more interested in learning from someone who's publicly beaten the market for 50 years versus say, someone who tweets that they've been in the market for 50 days.

Ricky Mulvey: Fair enough. I mean, I don't know, I think five-years might be fair at this point that would take you back to mid 2018. You've had at least one full cycle with mostly a bull market leading up to the crash of 2020, then the pandemic hype and then back to a bear market and then this very strange, odd bull market that we're in right now.

Anand Chokkavelu: I guess I always think of the fund manager Bill Miller, a growth investor who had 15 straight years of beating the market, then it fell off a cliff. I actually don't know where he's at these days because it's been a long time since then. But I guess for me, I'll always ask for more data.

Ricky Mulvey: Let's look at some ways that people have actually beaten the market. You can do it through some algorithmic models or you can look at some great investors who maybe you're able to pull off moves that, let's say the average investor like you and me cannot.

Anand Chokkavelu: That's right. Maybe some hedge fund algorithmic models can beat the market. Maybe someone like George Soros can beat the market making macro trades like as famous shorting of British pound and becoming the man who broke the Bank of England. But so what? Knowing their passenger planes that can theoretically go 1,500 miles per hour doesn't help me find a practical alternative to bookings Southwest.

Ricky Mulvey: It's a very good point. Then the other thing that's worth looking at is now getting into the fundamentals of how people invest. This is the short-term traders versus the long-term investors.

Anand Chokkavelu: Short-term, you can define as day trading, swing trading, which is like weeks-long trading versus buying and holding for years and decades. I'd say there's a lot of noise in the short-term, but in the long term it's more likely to come down to whether the company is strong and has a competitive advantage versus its peers. One thing on that short-term. The thing is, even if you could make money, even if short-term works, there are taxes which are stacked against you. Every time you book a gain, you pay taxes. The more often you do this and you're only holding short-term, you get dinged with taxes each time. Because you get a lower capital gains rate for long-term holdings versus short-term holdings, you're not only getting hit. More often, you're getting hit in larger amounts.

Ricky Mulvey: But I also don't have essentially infrared cables or not infrared cables, but the super speed cables that are able to grab market data in order to get a penny off a trade from a buy order and a sell order.

Anand Chokkavelu: I can't make AI algorithms to help me. Also, while there may be those things as going back to those planes, but there are also, traders over a different period of time. I can't explain it as well as Nassim Nicholas Taleb, he wrote The Black Swan, but I actually liked his book Fooled by randomness. They're both part of a series. But it covered some of those topics, and he was a Wall Street trader. And he talks vividly about different Wall Street traders he knew who are doing great for awhile each year they'd book huge bonuses. Everyone would be jealous. Then they'd blow up an epic fashion one right after the other. Even the success stories, given enough time, can be unsuccessful stories.

Ricky Mulvey: I mean, since I'll stop you on fooled by randomness for a little bit, what are some of your big takeaways from reading that?

Anand Chokkavelu: I mean, basically, so he had like five books that I think it's the Incerto series. It basically all makes the same point of that black swan point that we underestimate the long tails. That's what happens in these trading type of things of, the best chart thing he had. He had this awesome chart of the health of a turkey over time. He plotted it and then it falls off a cliff on thanksgiving. That's his whole thing, that there's this five bucks.

Ricky Mulvey: It's the metaphor of what picking up nickels in front of a steam roller. We talked about it on a previous episode this week with Bill Mann talking about a mortgage real estate investment trust company. This is a little bit of a side tangent. But it reminds me of basically when CEOs will start a conference call in two ways. The first of which is reflecting on business performance and discussing how great they are doing. Then the second way is offering a reflection of the macro-environment.

Anand Chokkavelu: Great. You can guess how the business is doing in that scenario.

Ricky Mulvey: You got under. It's a higher interest rate environment on. Let's take a look at maybe the technical analysis versus the fundamental analysis that investors use to try to achieve this goal. They sound pretty similar, but they're very different.

Anand Chokkavelu: Yes. Let's define our terms. Fundamental analysis is when you look at the underlying business to figure out how valuable a stock is. Things like sales growth, profit margins, the quality of the management team, PE ratios, price-to-sales ratios, competitive advantages, basically, all the things we talk about on this podcast. Technical analysis, on the other hand, ignores fundamental analysis completely and looks purely at a stock's past price movements and volumes to find patterns and trends in order to predict near-term stock moves. You'll hear a lot of smart sounding jargon, like simple moving averages, support and resistance levels and momentum indicators. Other colorful terms like candlestick, Elliot Wave, double bottom, head and shoulders. Ricky, I think you did some research on Elliot Wave?

Ricky Mulvey: Yeah. Let's break it down because I don't want to just gloss over it. The Elliot Wave is basically a belief that investors sentiment has predictable patterns in that a trader could basically trace this wave in order to make a profit. Now, here are the rules of the Elliot wave and really five movements, up, down, up, down and then question mark. Wave 2 cannot retrace more than the beginning of Wave 1. Wave 3 cannot be the shortest wave of the three impulse waves, 1, 3 and 5. Wave 4 does not overlap with the price territory of wave 1. That's where we started. Wave 5 needs to end with momentum divergence. Are you with me?

Anand Chokkavelu: Absolutely. That's where it should be. I was going to define a double bottom and give an example like that. It's a W-shape pattern and a stock price, but I don't need to, that was perfect. I think that gives you what you need. Where it's these pattern things, I simply don't get it. If you want to get technical about it, it sounds like a great case of apophenia to me. That's where humans see patterns and meaning where there is none. This might be a bad analogy, maybe we'll even cut this out. But, it's a football analogy. It's third and 14, the last two plays have been runs for losses. A technical analyst might say, this one's going to follow the pattern. It'll be another run. A fundamental analysts might say, that's ridiculous, it's going to be a pass because you're very unlikely to gain 14 yards on a run.

Ricky Mulvey: The technical analyst is basically looking at what long-term investors would describe as independent events, and then trying to ascribe meaning to them for the future.

Anand Chokkavelu: Completely ignoring the income statement, the balance sheet, cash flows.

Ricky Mulvey: Now, we've gotten the long-term, we've gotten the short-term, so we're going to stick with long term. That might be a surprise to Motley Fool listeners, but we're going to stick with the long-term on this one. You have the two camps, and these two camps do not like being divided among themselves. But, the two camps are value investing and growth investing. In both of these, people have successfully beaten the market using both methods.

Anand Chokkavelu: Unlike the other two, where we're for long term, we're for fundamental not technical, value investing versus growth investing gets a little interesting. Spoiler alert, it's both. But, let's talk about value investing. The best case for value investing was made back in 1984. Believe it or not, almost 40 years ago, Warren Buffett wrote The Superinvestors of Graham-and-Doddsville. That's Benjamin Graham and David Dodd who wrote the book Security Analysis. The original work of value investing back in 1934. You add those two right, 50-year anniversary for about 40 years ago, it's almost 90 years since that was written. As Buffett puts it, this brand of value investing is simply look for values with a significant margin of safety relative to prices. In this The Superinvestors of Graham-and-Doddsville, Buffett addressed, coin flipping and data mining versus knowing who's going to win beforehand. Basically, what he's saying is all these people who followed what Graham and Dodd's said. The proof is in, he knew these people and sure enough, they beat the heck out of the market and he showed that using their returns over time. He had a group of nine people, including himself and his partner Charlie Munger, even when they were working independently. Stuff like Tweedy Browne, which is a famous mutual fund now, Walter Schloss, Will Ruane of Sequoia Fund, not to be confused with Sequoia Capital, the venture cap firm, this is a value investing in mutual fund, and then a bunch of other places and he gives the long-term track records of each and how handily they beat the market. You're talking double and triple times the market in lots of cases.

Ricky Mulvey: The pushback on that though, this was in the '80s before you had the power of the Internet. That is when one could go to a library and check through a financial report, see that there's a stock is now trading at a discount to book value. It's very easy to find that margin of safety, and then you can make a profit by looking through the couch cushions. I don't think that particular style of value investing maybe works today, now that you have AlgoTraders and that information is readily available to everyone, it's harder to have that information edge. I'm not saying that's easy, I think there's a different version of value investing that's still works, but I think that older school version is much more difficult to pull off.

Anand Chokkavelu: In fact, Buffett went away from the pure Graham style of investing. Because those net type of things as really numerical things. Because like you said, back then, you didn't have the access to information everyone has now. Even in 1984, if you reread that definition Buffett gave, he makes sure to make it general enough that it's timeless. Look for values with a significant margin of safety relative to prices. Basically buying for less than it's really worth, and we will see that a little with growth investing.

Ricky Mulvey: It's worth giving Buffett some credit here. Because even though right now he's shooting with an elephant gun, he can't look at smaller cap companies with the amount of money that Berkshire has, and yet Berkshire's still beaten the market is an asset manager. Over the past five-years, Berkshire B-class shares returned about 75%, while the S&P 500 total at the time of this recording returned 61%. That's without dividends so you can bump that up a little bit. But, I still think that he's making a strong case for his style of investing.

Anand Chokkavelu: Absolutely. If you look at the long track record, he's still over decades and decades 20% about double the market. It's amazing.

Ricky Mulvey: Maybe the new styles looking for more, let's say places that investors are ignoring, even though the information is out there. There's still plenty of areas where people ignored because it's boring or it's harder to understand. Then there may also be cases where investors and just people have a very short attention span. If you find what a narrative is in the market versus what you think the narrative actually is for a company, and where there might be more nuance and complexity, I think that's where maybe more of the modern value investors reside; finding the variant perspective.

Anand Chokkavelu: The tactics change, but the strategy overall stays the same.

Ricky Mulvey: Let's look at growth investing and how people have beaten the market using that style.

Anand Chokkavelu: That's simplify. Whereas like value investing focuses on price, growth investing focuses on, you guessed it, growth. Value investing is about the floor, growth investing is about the ceiling. Put it another way, value investing is often about base hits, while growth investing is more often about a few multi-bagger home runs making up for a lot of strikeouts. On-base percentage versus slugging percentage.

Ricky Mulvey: You might have to contend with a little bit of loftier valuations. Last week we welcomed David Gardner and Tim Beyers on the show to talk about the fundamentals of Rule Breaker Investing. I think this is what you are hinting at with this description.

Anand Chokkavelu: Absolutely 100%. To be fair, to growth investing where we ran down a whole list of those super investors of value investors, well, here are some of the growth investors. Peter Lynch, Thomas Rowe Price junior who founded T Rowe Price. The man, not the company. You know what, we'd be remiss on this podcasts not to mention the Gardner brothers, Motley Fool's returns in Stock Advisor and Rule Breakers that they speak for themselves. Philip Fisher. If you haven't heard of Philip Fisher, Buffett says his investing sells 85%, Benjamin Graham, 15% Philip Fisher. Blending those value and growth properties, they're just different flavors of the same ice cream though. In either case, you're just trying to, that Buffett definition holds. Maybe not the margin of safety so much, but you're just trying to buy a stock for less than the businesses truly worth.

Ricky Mulvey: I think in the growth style, it is more bets on companies that could have an explosive potential farther in the future and you have, let's say, a higher risk tolerance from folks who are looking to buy maybe an ETF. Because you have a higher risk tolerance, you're allowing yourself more losses for a couple of big homeruns. But you made a really good point that, is a theme here on it, which is that both styles work. Even in the case of Buffett, he's made bets on Chinese electric car manufacturers with BYD. He's played ARB games with Activision Blizzard. You don't have to follow a strict philosophy in order to pull this off.

Anand Chokkavelu: I think if he was born now or lets say 20 years ago versus when he was born in 19, was it 30. I think he'd have a slightly different style. I mean, I think you'd figure it out quickly and stick to it, but I think you have to adapt to what is available in the market and how the information is.

Ricky Mulvey: Yeah, and Buffett also break some of the rules about portfolio concentration.

Anand Chokkavelu: Yes, we should talk about that. Should you own very few stocks or a ton of stocks?

Ricky Mulvey: Yeah and, we were talking about this before the show. You have your Peter Lynch side, which is when he was running his fund at Fidelity at one point he had, what is it, 1,400 stocks. You brought up a good point which was for this recording. Which is we don't know what the top concentration was, but that is vastly different from Buffett's letting his one-winner run tremendously.

Anand Chokkavelu: I mean, if you look at his portfolio now, the publicly owned stocks that he has in his portfolio also own businesses within Berkshire Hathaway, but almost half is in one stock, Apple 47%. If you look at his top 10 holdings, 86% are in those top 10 holdings. Even, even as we give the Peter Lynch example, it's definitely easier to beat the market with fewer stocks. But because diversification generally takes it closer to that market average, but it's also easier to spectacularly lose to the market with fewer stocks. If you're Warren Buffett, you probably want to be concentrated. If you're managing other people's money and charging them a fee because you think you can beat the market, you want to be concentrated, those people can also own other things to diversify themselves. That makes sense, but as an individual investor, you're managing your own money and your own life and you have to be comfortable with the risk you're taking on. One practical solution if you want to be concentrated but also mitigate risks, you can buy low-cost index ETFs for part of your portfolio and then buy a concentrated group of stocks that you've studied and you love with the remaining portion. For example, someone indexing 90% of their portfolio can be about as concentrated as they want with the remaining 10% because they'll still be well-diversified and they won't be taking a huge risk.

Ricky Mulvey: I wonder what's the Buffett example? How much of that is a "don't try this at home" with basically half of the concentration in one stock? It works spectacularly well with Apple, but there may be other examples of fund managers or individual investors who went super concentrated in one area and it just didn't work out for them. But that's not as fun of a story to talk about.

Anand Chokkavelu: By the way, there's a reason Buffett is indexing his wife's, when he goes away, he's indexing the money that she'll have.

Ricky Mulvey: I think, there's a little bit of machismo with that. Because with Buffett, if you're doing the index for all of your money after you die, there might be a little bit of a 'no one can do this as well as I can' mentality. It's the dividend thing. I really like companies that pay me a dividend, but I will never pay one because I am a superior capital allocator. You know what, he might be right about that. I've talked myself and I'll loop back to agreeing with him.

Anand Chokkavelu: No. You know what? I pretty much 100% agree with everything you just said. But it's the thing of, hey, you know what, you can't do what Warren Buffett does. Like Ricky you are basketball player. You know, some of the things Michael Jordan did might not be exactly what you need to follow up.

Ricky Mulvey: Yeah. It's called the analogy would be goal tending. It is a foul that I simply cannot commit because I am not able to jump above the rim and swat a ball out of the air on its way down. [LAUGHTER] There's something there. But let's talk about actively managed mutual funds that came up a little bit earlier. Obviously, your Peter Lynch investor would be a big fan of that in part because he ran an actively managed mutual fund. But some folks are able to beat the market by picking the jockey.

Anand Chokkavelu: Yeah. Absolutely. Here's the thing about mutual funds, is there are two problems with trying to beat the market by picking a group of actively managed mutual funds. One, there's a logical fallacy, where if you're skilled and experienced enough to pick the market beating fund managers, which remember like almost none of them beat the market over a long period of time. The percentage is like 80% or higher that don't and I think it gets higher the longer period you look at. If you can pick these winners, you're probably skilled enough to pick market-beating stocks because you'd have to know the two. Then the second thing is that it's probably the more important thing, is it mutual funds are structurally they're set up to fail. Not on purpose, but they are because even if you find a young market-beating fund manager, once the fund gets bigger, it's harder to beat the market. We talked about that with Buffett and having to use an elephant gun. Buffett said that he had a smaller like a million-dollar portfolio, he could get 50% annual returns. I believe it, but Berkshire Hathaway has been the size of a large mutual fund the last few decades, and he's noted it and the performance has shown. It's just trying to stay in line with the market. Then a second thing that's problematic structurally is, even if you personally have the stomach for down-markets, your fellow mutual fund holders get scared and pull their money out right when they should be putting money in the lows of the market. When they pull their money out, your star manager has to sell those now undervalued stocks then it's the opposite when those folks throw their money back in the market highs. Then the third thing is the fees are much higher than passive index funds. You're getting charged for this structurally complex piece.

Ricky Mulvey: It takes away from the ingredients we've described of beating the market. One of which is an understanding of value, a willingness to be a contrarian, maybe a smart contrarian because often the crowd is usually right. Then also that long time horizon, the Lynch book, which we covered in a book club. He points out, and I think it holds true his biggest gains tend to be past year three of owning a stock. What is the conclusion? Where did we end up on how investors can beat the market?

Anand Chokkavelu: The summit altogether, there are lots of paths up the mountain, both value and growth can work, dividends can work both a concentrated or a diversified portfolio can work, etc. By long-term buy-and-hold beats short-term trading, fundamental analysis beats technical analysis. Most importantly, finding and sticking to a system beats going all over the place. If all of that is too complicated for you, ain't nothing wrong with matching the market with a passive index fund. We've been talking about beating the market, but matching the market's great. Historically that's meant doubling your money every decade or so.

Ricky Mulvey: I'll also throw in, I think it's a the willingness to look where others are not in railroad stocks. Railroads have consistently beat the market for a very long time. [laughs]. I don't know if that will continue that way, but they have a track record. Anand Chokkavelu, always pleasure chatting with you. Thanks for joining us today.

Anand Chokkavelu: Thanks, Ricky. Always a pleasure.

Mary Long: As always, people on the program may have interest in the stocks they talk about and the Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I am Mary Long. Thanks for listening. We'll see you tomorrow.