Stock Selection and Changing Market Realities

Conviction, Skill, and Market Realities

Trying to beat the market to the best ideas has never been easy. And it only gets harder when the market is dominated by large price moving institutional demand. In addition, recent trends indicate the supply of publicly held stocks has dwindled. That makes the competition that much more fierce for a limited supply of companies to select from. Finding an informational edge to consistently profit against institutions is a low probability:  50-50 at best….before fees.

Stock Selection: “Conviction in Equity Investing” by Mike Sebastian and Sudhakar Attaluri, appeared in the Summer 2014 issue of The Journal of Portfolio Management. It found that the percentage of skilled managers was about 20% in 1993. By 2011, it had fallen to 1.6%. This is what Ben Graham and Charles Ellis referred to in 1975, as the trend of institutional dominance makes it even more challenging for active managers to outperform the index. Institutions effectively are the market. How can you beat the market if you are the market and you’re adding fees? The math works against you as the studies indicate.

Yet still another factor working against the active manager is fewer companies to choose from. In the last 20 years, the U.S. stock market has undergone an alarming change. Between 1996 and 2016, the number of listed companies fell by half, to 3,600, down from 7,300, according to a Credit Suisse research study.

Market Concentration: in August 2020, a study showed the 10 largest stocks in the S&P 500 account for about 28% of market capitalization. The Anti-Index camp asserts that this is dangerous. High market concentration risk implies these assets are “overvalued.” First, making valuation calls is never a precise science. Second, over the past forty years the top 10 has ranged between 17.5% and 25.5%.¹Howard Silverblatt, “Top-Heavy Stock Indexes Are Nothing to Fear,” Advisor Perspectives, August 19, 2020. We’re currently a little above the range.

A recent Fidelity study took a similar approach and examined large cap growth stocks outperformance against the S&P 500. As their profits have risen, so have their stock prices. Yet their valuations and concentration remain less extreme than prior periods of high concentration in 2000 and in the 1970s.

The pandemic has caused a shift in sector economics (i.e., travel and hospitality have not done well while technology has gained because it is a vital infrastructure that enables work from home). Industry sector shifts have occurred throughout history, yet their duration and sustainability are never certain. These shifts and reversals are common in capital markets. Indexing ultimately captures such shifts without trying to time these movements and is a steady long-term bet on the overall market(s).

Many regard Warren Buffet as the greatest investor in our lifetime. It’s worth revisiting his words to his Trustee:

“Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”

Warren Buffet