Can an amateur identify winning stocks ?

Small caps

Dogbert

Not so sure about fund managers being over-exposed to small-caps. With so many companies across the globe many managers try to break the investable world down, firstly by screening out stocks below a certain market cap. This almost all but rules out managers being overexposed to small-cap stocks.

Another factor conspiring against small cap investment by fund managers is that idea generation for fund managers often relies upon sell-side analysts. Small cap stocks are not widely covered by the main brokerage houses and are therefore rarely put in front of fund managers. It is usually the large-cap stocks that make the grade here.

I would presume that fund managers are generally more exposed to mid-caps than they are small caps. It's hard to tell from performance figures what the situation is.

At any rate, the bull market in the mid/ small cap arena has probably played out reasonably fully, with the valuation gap narrowing considerably. There may not be much more to play for here. Then again just as technology led the last bull market, maybe the next phenomenon is just starting.

Great Debate

Thanks guys, I'm enjoying this debate.

Bearish - you'll see I said that in my experience what leads the underperforming managers (and to a large extent the day traders) to underperform is the costs they incur. So I don't think it <!--EZCODE BOLD START--> is<!--EZCODE BOLD END--> the case that they are leaving wads of performance on the table for other investors. They underperform because they trade too much and don't add any value through so doing, and, in the case of fund managers, they cause their clients to underperform because they charge them fees for so doing.

Fairfield - fair enough, I really meant non-large cap. Managers aren't looking to add value through their positions in Vodaphone or GM or NTT, but from stocks further down the capitalisation chain.

We've got a long way from my first post on this thread, which was to disagree with Bearish's conclusion that
<!--EZCODE QUOTE START--><blockquote>Quote:<hr> Stock picking would appear to be a better strategy for now.<hr></blockquote><!--EZCODE QUOTE END-->

I still haven't seen anything to change my mind on this. Where does everyone else stand ?

stock-picking

I said previously the blanket 'equities are over-valued' statement is hard to substantiate- the key question for me is not the source of the inefficiencies, but how to exploit them.

One angle that hasd not been mentioned is the 'passification ' of active management post the Unilever case .This has already resulted in very large chunks of the UK equity market being managed by reference to the FTSE 100/All Share within specified tracking margins.This means that quite a lot of the actively managed money is quasi- indexed.

The issue of market cap certainly is related to the coverage from the sell-side, but has at least as much to do with liquidity - Fund managers cannot get trapped in positions which might equate to several day's trading volume in a stock.

Certainly,smaller-caps have been ignored and a lot of value was left behind.

Costs v Short-termism

Dogbert

Quote:
“Bearish - you'll see I said that in my experience what leads the underperforming managers (and to a large extent the day traders) to underperform is the costs they incur.”

Costs are definitely a factor for underperformance, but fund mangers short-termism also plays a large role. There is therefore an opportunity for individual investors willing to take a long-term view to benefit from this. Just to be clear when I talk about stockpicking being the optimal strategy I am referring to individual stock pickers, not active fund management.

Equity Markets

<!--EZCODE QUOTE START--><blockquote>Quote:<hr> Just to be clear when I talk about stockpicking being the optimal strategy I am referring to individual stock pickers, not active fund management.<hr></blockquote><!--EZCODE QUOTE END-->

Thanks for reminding me, Bearish - I keep forgetting about that.

But if I accept your premise, then wouldn't that be true in good markets as well as bad ones. Managers' short-termism is no more dangerous in the current scenario than it was three years ago. I'd have thought it's less so, in fact, given that most managers tend to respond to bear markets by sitting on their hands and letting cash build up in their portfolios.

That's a source of lost opportunity for them if markets rebound, but if you're negative on markets, as you are, doesn't that lessen rather than increase the opportunities available ? Unless of course you're thinking of the volatility point raised earlier by Fairfield. As I said then, I think all that does is add to the spread of potential returns, not make it any easier for an investor to outperform.

RE: Equity Markets

Quote:
“Managers' short-termism is no more dangerous in the current scenario than it was three years ago. I'd have thought it's less so, in fact, given that most managers tend to respond to bear markets by sitting on their hands and letting cash build up in their portfolios.”

Quote:
“if you're negative on markets, as you are, doesn't that lessen rather than increase the opportunities available ?”

I may well be negative on markets as a whole, but not on certain individual stocks. When bearish sentiment takes hold of a market, both good and bad company share prices can be pushed down, leading to significant opportunities to acquire some great companies at knock down prices, i.e. the share prices becomes detached from the underlying fundamentals of the business. From my own experience the opportunity to acquire such undervalued businesses tends to be greater in a bear market than a bull, as the twin actions of active fund managers reducing their equity positions to move into bonds/cash and hedge funds shorting activities can temporarily push stock prices down far below their fair value.

Individual Investors

Hi Bearish,

Was doing some reading on the Motley Fool (I generally use the US rather than the UK site), and re-discovered an article from early 2000 by Whitney Tilson (who writes frequently for the Fool) that I'd forgotten about that brought me back to our recent great debate.

It summarises better than I can the case I was trying to make in this thread. Beating the market is hard to do, for individual investors as well as fund managers (each suffers from a different set of disadvantages), and the vast majority of people will be better off in the long-run in index funds. There are occasional Warren Buffetts, to be sure, but they stand out precisely because they are very rare. Betting (in any serious way) that I'm another Warren Buffett is probably poor odds to take. So I run most of my assets through low-cost index funds, and do some stockpicking at the edges ... for fun/education/interest rather than as a key plank of my investment strategy.

I'd be interest in any comments on the article [broken link removed].

Re: Individual Investors

Hi Dogbert

A good article - thanks for highlightin it.

It reinforces the policy of not allowing discussion of individual shares on Askaboutmoney.

Brendan

Re: Individual Investors

Dogbert,

A well thought out article and quite timely in Jan 2000. I think most objective observers would have agreed with those comments in 2000. Too many private investors with too much money and too little knowledge thought that by watching CNBC for a few hours, they could make a killing buying stocks based on a recommendation from a CEO or analyst been interviewed that day. In fairness to these less “market savy investors”, there weren’t many people advising them to do anything else but buy shares in 2000. Analysts, brokers and the media showed little objectivity in their analysis of equities back then. It reminds me of the current coverage of the Dublin property market. But that’s another debate altogether! Still at the end of the day its buyer beware. If you throw your money into something you don’t fully understand, just cause others are doing it, you have to accept the consequences of your own actions.

I agree with the article’s argument that investors with little knowledge and time should not try DIY stock picking. If you have little or no understanding of security analysis and don’t have the time or inclination to learn more about the subject then I’d agree with you that investing in an index tracker is probably the best choice, assuming you have a long time horizon, i.e. at least 10 years, but best to have a 15-20year view. The reason I say this, is that a number of times during the 20th century, various indices have stagnated for periods of 10year+. Having had a bull run from 1982 to 2000, investing in an index looked easy, however since then its been painful. You or I don’t know how long this bear market will continue, but as historical valuations suggests we still have a way to go, I’m reluctance to promote index funds. Without being able to predict the future, I’d say the average Joe with little interest in equities and even less time to learn about them should go for an index tracking fund if they can take a 10-20 year view. Anyone with an investment horizon below this should be in cash or bonds.

That said, I really do believe that people who have an hour or two each week to brush up on their security analysis skills can, over the long-term, outperform both active fund managers and index trackers, particularly in these markets where there are some real bargains. When I say security analysis skills I’m not talking model building, just being able to identify when a stock might look cheap based on its P/E and dividend yield, being able to understand a company’s industry and competitive dynamics, and actually reading the annual report of a company when it comes in the door. It really isn’t all that hard. Sure it takes a little time getting up the curve and investing isn’t everyone’s cup of tea, but if you want to make some money over the long-term I can’t think of anything else that is as easy. Just reading the fool sites will give the novice investor a few ideas they can further investigate.

As with most things in life, it really comes down to a person’s individual choice as to what they are most comfortable with. Personally I prefer stock picking, although I am in index trackers from a diversification point of view. However, I’m not satisfied with just getting an average return from an index tracker. The average over the past couple of years has been crap to say the least. Am I arrogant in thinking I can beat the average? Maybe. Or maybe its just I’m a little more confident in my own ability to identify companies that are likely to generate above average returns in the long-term. In the absence of any studies looking at index trackers versus private investor stock picking skills neither of us can make any definitive conclusions, but then that’s what makes a good debate.

Index v Active

Further evidence that the professional investors are not beating their index benchmarks (whatever about the non-professionals that Bearish was representing) in this article from Vanguard's website.

Over 5-years the index beats the average manager, comfortably in most cases, in 9 of 9 style categories of US equities. Over 6 months to end-June, the index beats the average in 7 of 9 categories. So the stockpickers haven't been thriving, even in the bear market, and even in small caps.

On reflection, I should have phrased that previous comment "the average manager has failed to beat the index", because the article pooh-poohs the idea of indexers trying to beat anything, whereas active managers are clearly trying to beat their benchmarks.

[broken link removed]

Index v Active Again

Further evidence that all the guff we're hearing these days about this bear market being a "stockpicker's market" is just that. Bottom line: In 2002, the average actively managed US mutual fund underperformed its index benchmark in seven of the nine Morningstar style categories. Value funds had a slight edge over the index in the large-cap and small-cap categories.

LARGE-CAP FUNDS (indexes beat funds 2 of 3 categories)

Large-cap Growth (index wins by 4.0%) The average large-cap growth fund lost 27.6%. The index only lost 23.6%. And 78% of the funds failed to beat their index.

Large-cap Blend (index wins by 1.0%) The average large-cap blend fund lost 22.2%. The index lost 21.2%. And 59% of the funds failed to beat their index.

Large-cap Value (funds win by 1.9%) The average large-cap value fund lost only 18.9%, while the index lost 20.8%. And 68% of the funds beat their index.

MID-CAP FUNDS (indexes win all 3 categories)

Mid-cap Growth (index wins by 8.3%) The average mid-cap growth fund lost 27.4%, while the index lost only 19.1%. And 86% of funds failed to beat their index.

Mid-cap Blend (index wins by 2.4%) The average mid-cap blend fund lost 16.9% while index the lost only 14.5%. And 54% of the funds failed to beat their index.

Mid-cap Value (index wins by 2.9%) The average mid-cap value fund lost 13.0% while the index lost only 10.1%. And 66% of the funds failed to beat their index.

SMALL-CAP FUNDS (indexes win 2 of 3 categories)

Small-cap Growth (index wins by 13.0%) The average small-cap growth fund lost 28.3%. The index only lost 15.3%. And 95% of the funds failed to beat their index.

Small-cap Blend (index wins by 1.2%) The average small-cap blend fund lost 15.5%. The index only lost 14.3%. And 54% of the funds failed to beat their index.

Small-cap Value (funds win by 4.1%) The average small-cap value fund lost only 10.3%, while the index lost 14.4%. And 68% of the funds beat their index.

Note that the returns are pre-tax, and without adjusting for upfront charges, so the end-customer performance of the actively-managed funds will actually be worse than the above suggests.

Re: Individual Investors

Dogbert

Very interesting, but is there any explanation as to why the performance is so bad?

Index trackers are virtually 100% invested in the market. Actively managed funds often have some of their portfolio in cash, so actively managed funds should have a head start in a bear market and a disadvantage in a bull market.

Brendan

Index v Active Again

Hi Brendan,

You would have thought so, and also the "spin" of late is that this has been a stockpicker's market, because so many of the very poor performing stocks would be so obvious that most active managers would avoid them.

But that's not borne out by the figures. So I would interpret the data as demonstrating that it's no easier for active managers to add value in bear markets than it is in bull markets. It corrobrates the longer-term data I posted earlier in the thread.

In fairness, most specialist US mutual funds run very low cash weightings at all times - they don't allow cash to build up even when markets are poor. The logic behind this is that their clients select them to gain exposure to the respective market sectors, not to perform asset allocation. So the cash build up in a specialist equity fund tends to be very low, whereas for an asset allocating managed fund it may be a lot more significant.

In fairness also to Bearish and other posters on the earlier thread here, this data is the record of professional, not amateur, stockpickers. I just thought it was easier to add the up-to-date data to an existing thread on this broad topic rather than to create a new one.

Just came across this article which might be of relevance to this discussion although there's nothing new in there really...