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:

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.