The most
common form of active management is stock picking. On average, stock
pickers will always lose by the amount of their costs and expenses.
Some will do better and some will do worse than an appropriate or blended
benchmark of risk factors. Since the average return of the market is
the average return of all investors, the average investor gets the average
return. Although you may think that you can choose or be the investor
who beats the others, the probability of a money manager outperforming
other managers each year is equal to getting heads on the toss of a
coin: 50/50. This is because the markets are random, just like a coin
toss. The chances of a manager beating a market over the long term (more
than 10 years) were 1 in 36 in one study, and 1 in 39 in another 30-year
study! You would be better off betting on one number on the roulette
table in Vegas, where odds are 1 in 38. So far, we have collected over
200 articles measuring the performance of active managers, starting
with Alfred Cowles in 1933, and the results are not good for active
management.
Stock
pickers are active investors who bet they can beat a market by picking
stocks they believe will outperform an index. To be precise, the only
proper comparison to their result is the portfolio they choose. All other
portfolios will end up with different risk and return characteristics.
Generally, stock pickers take on more risk than the index because they concentrate their bets on fewer stocks than those in the index. When
they allocate their portfolio differently than the index, they are guaranteed
to obtain a different return as well as a different risk level. Sometimes it is more and
sometimes it is less, but we can always assume it will be different when
looking at both risk and return. Since it takes at least 20 years of risk
and return data to confirm skill over luck, stock pickers face a virtually impossible task in their ability to ensure continued success against the
appropriate market index. However, indexes are a source of 20-year risk
and return data, and consequently are the only logical choice for establishing
efficient portfolios of various levels of expected risks and returns.
The performance of
stock pickers must be examined on an adjusted basis. This means that all
factors must be considered before we can determine if the stock picker
has achieved a benefit over an appropriate index or benchmark. When comparing
active management to an index, we must:
1.
Make sure we are talking about the entire portfolios for the exact same
period of time.
2.
Confirm proper accounting of the returns, including the cash flows in
and out of the account.
3.
Consider the state and federal taxes paid on short and long-term capital
gains and dividends.
4.
Consider all fees when assessing net return. Most funds report gross performance
before deduction of fees and commissions.
5.
Adjust for the portfolios' exposure to market risk, size risk, and value
risk factors.
6.
Consider the level of diversification of the two portfolios.
7. Analyze the standard deviations or volatility measurements.
8.
Consider if the over and underperformance is within the bounds of what
would be expected randomly.
9.
Be sure to compare results to an appropriate benchmark. Proper benchmark
specification avoids inflated performance reports.
10.
If looking at a group of stock pickers, be sure to include the returns
of those pickers that did not survive the duration of the period, usually
due to significant losses.
11.
Look at all active managers in an asset class, both those who stayed
in business and those who did not.
12.
Check to make sure the stock-picking manager did not drift in its designated style during
the period in question.
Making these comparisons requires a high degree of understanding of each
of the concepts listed above. To simplify your analysis, you may consider
that the only way to end up with a different performance than the index
is to own investments different than the index. Since an index is the
only source of long-term risk and return data, why would any investor
choose something other than the index? The only question should be: What
mix of indexes is appropriate for you?
Lets take a closer look at why stock pickers lose on average.
The main reason that stock
pickers fail is that stock prices are moved by news, and news is unpredictable
and random in nature. Therefore, the movements of stock prices are unpredictable
and random.
This simple logic makes it impossible for any human being to consistently
pick stocks that outperform the averages of a market.
Secondly, the news that moves stock prices is incorporated into the new
price within minutes of its release. This adds a major hurdle for stock
pickers. It means they must compete with thousands of highly intelligent
and well-informed traders on a minute-by-minute basis.
John Stossel of ABC’s 20/20, reported a story on the perils of picking
stocks. Stossel interviewed Professor Burton Malkiel of Princeton University,
author of the book, "A Random Walk down Wall Street." In the interview,
Professor Malkiel said that stock markets historically deliver a performance
of 9.5% to 10% compounded per year over the long haul. Inquired Stossel:
“To beat that average, should an investor listen to the Wall Street
professionals?”
“No,” replied Professor Malkiel. “All the information
an analyst can learn about a company, from balance sheets to marketing
material, is already built into the stock price, because all of the other
thousands of analysts have the same information. What they don’t
have is the knowledge that will move the stock, knowledge such as a news
event, which is unpredictable and impossible to forecast.”
Indeed, an analyst can only guess about a future event, which is no different
than throwing a dart at a newspaper while blindfolded to find a stock.
Both events are unpredictable. The main purpose of the financial research
industry is to try to predict the future course of events since that is
the only thing that will drive future stock prices. If thousands of highly
intelligent, sophisticated analysts with degrees from top universities
and access to the best computing power available can’t predict the
future, what use are they? How can one company or research analyst have
more knowledge than another without it being inside information, which
would be illegal?
“Survivorship
bias” is one of the many reasons that stock pickers’ returns
look better than they actually are. Survivorship bias is when mutual fund
managers tout their fund’s performance based on comparisons with
an “average” mutual fund. This average is calculated from
a list of funds that have survived during a particular period. Funds that
did not survive the period are not included in the calculation. According
to the Center for Research on Securities Prices (CRSP) at the University
of Chicago, if only data from surviving funds is considered, the growth
of a dollar for the surviving funds appears to be 19% better since 1962.
If only “live growth and income funds” are considered over
this period, $100 appears to grow to about $2,500. However, the only way
to properly account for all active managers is to include those mutual
funds that did not survive. When taking these dead funds into account,
CRSP found that the average stock picker’s $100 investment grew
to only about $2,100.
Rex
Sinquefield
Difficulties
of Stock Picking
Part 1
Rex
Sinquefield
Difficulties
of Stock Picking
Part 2
The Center for Research on Securities Prices (CRSP)
at the University of Chicago has the only complete database of both live
and dead mutual funds.
Mark
M. Carhart, currently Co-Head of Quantitative Research, Goldman Sachs
Asset Management, New York, developed this unique database for his 1995
Ph.D. dissertation at the University of Chicago Graduate School of Business.
In his dissertation, Survivor Bias and Persistence in Mutual Fund Performance, he noted that the explosion in new mutual funds has been "...accompanied
by a steady disappearance of many other funds through merger, liquidation,
and other means...this data is not reported by mutual fund data services
or financial periodicals and in most cases is electronically purged from
current databases. This imposes a selection bias on the mutual fund data
available to researchers: only survivors are included.."
In estimating
the performance of an equal-weight index of equity mutual funds, Dr. Carhart
found that analyzing only surviving funds biases performance upward by
about one percent per year.
The CRSP database includes 24,725 mutual funds from 1961 to 2004. In that
time, 8,710 of the 24,725 mutual funds died. That means that more than 35% percent of
mutual funds data is not included in the average returns of active managers.
The active managers who run them happily bury most of the data about dead
funds. Is it possible that the 8,710 dead mutual funds had high returns
for their investors?
The financial press goes to great lengths to inform the public about active
managers with good luck, e.g., "Last Year's Top Ten Mutual Funds."
This kind of media reporting provides no data about those managers
who lose money taking chances in the market, then shutting their
doors and erasing their bad returns from the record. Well, we have bad
news for those mutual fund managers: we are exhuming their results. We
paid CRSP $1,000 (it is expensive to dig up old corpses) to prepare a list of the top
200 worst performing dead mutual funds going back to 1961. To our
surprise, this had never been done before. Here are the top twenty of
the worst performing dead mutual funds:
These two video clips are an explanation of survivorship bias by
Rex Sinquefield, past Co-Chairman of Dimensional Fund Advisors.
In addition to funds
that die, there is an indeterminable number of funds that are aborted.
These funds are referred to as incubator funds, and are basically experiments
within a fund firm that never develop into a publicly available mutual
fund.
Upon their inception, the funds are not available to the public; therefore,
they are safe from public scrutiny. After a time, the fund shop rolls
out only the best performing funds. And some of the best performing funds have unusual reasons for performing so well, like limited access to IPOs. Click here to see an SEC case on this issue.
The stock picking
managers of these incubator funds tried something new and ended up with
a failure. This little known fact has yet to be quantified in the average
returns of stock pickers.
Finally, there are
the revolving doors of stockbrokers who are churning through clients and
constantly rotating from one firm to another. Their records are quickly
extinguished, never to be counted in the average of stock pickers.
This Wharton School dissertation paper explains fund incubation as a "strategy for enhancing return histories . . . the process of running lightly-capitalized, self-funded investment accounts in a semi-private environment." The dissertation in finance for Richard Evans states that the fund returns of funds emerging from incubation was 18% per year above the average return of funds when discarded funds were included. Mr. Evans cited an incubated fund that produced a three-year annualized return of 28.79%, which resulted in a Morningstar "5-Star" rating. About 125 incubator funds have come and gone in a ten-year period. The study concluded that the funds that made it out of the incubator had severe return reversal after the funds were offered to the public. This is indicative of the returns being explained by luck, rather than skill.
Two of the largest fund firms implicated in the recent scandals were among the major participants in this strategy. They started with large numbers of incubation funds in order to, in the paper's words, "upwardly bias investors' estimates of their ability, and thereby attract additional inflows," killing them off when the tough real world of investing brought their returns back down to reality. This is described as "organizing, operating, and managing" funds in the interest of their promoters to the detriment of their investors. Investors would benefit from a restriction of the promotion of the returns earned by these incubated funds during their incubation period.
In addition to dead mutual funds, there is a huge graveyard full of
dead companies. Table 3-2 lists the largest bankruptcies.
Table
3-2
Indeed, only two members of the original 30-stock Dow Average established in October 1928 are still included in 2011 - General Electric and Standard Oil of New Jersey, now ExxonMobil.
Two examples of bankruptcy filings help remind investors how easy it is
to pick the wrong stock. The first example is Bethlehem Steel. Bethlehem
Steel was founded by legendary steel tycoon Charles Schwab in 1904 in
Bethlehem, Pennsylvania. The company produced some of the nation’s
first steel railroad rails, revolutionized high-rise building construction
with the introduction of structural I-beams in 1908, and built the country’s
first aircraft carrier in 1925. Landmarks such as the Golden Gate Bridge,
the Chicago Merchandise Mart, Rockefeller Center and the U.S. Supreme
Court were constructed with Bethlehem steel. Peacetime employment reached
a peak of 157,000 workers in 1957, and profits hit a record $426 million
in 1988. In 2001 the mammoth steel company filed for Chapter 11 bankruptcy.
Bethlehem was one of the stocks in the Dow Jones Industrial Average for
nearly 70 years until it was replaced by Johnson & Johnson in 1997.
Its stock price reached a peak of nearly $60 in late 1959 and remained
in a broad trading range over the next 40 years, as the firm struggled
to improve its competitive position through various acquisitions, divestitures,
and cost cuts.
Indeed, only three members of the original 30-stock Dow Average established
in October 1928 are still included in 2005: General Electric, General Motors,
and Standard Oil of New Jersey, now ExxonMobil.
Another example is Polaroid Corp., which was founded in 1937 by 28-year
old Harvard dropout Edwin Land. Land was a brilliant physicist and tireless
inventor who accumulated 535 patents by the time of his death in 1991
(second only to Thomas Edison). An early quest to solve the problem of
headlight glare led to a patented process for polarized glass, and a variety
of optical products for military and commercial use. The self-developing
Polaroid Land camera he ultimately developed was a marketing sensation
when introduced for $89.50 in 1948. A steady stream of improvements including
instant color film stoked consumer interest in the 1950s and 1960s.
Figure
3-1
Polaroid shares were
a favorite among aggressive investors, soaring more than 40-fold from
their initial public offering in 1957 to an all-time high of $149.50 in
1972 ($74.75 adjusted for a subsequent two-for-one split). The SX-70 camera,
which ejected prints that developed externally, was introduced the same
year. In addition, there was talk of a forthcoming instant movie system.
What’s more, in 1991, a successful patent infringement lawsuit against
Eastman Kodak appeared to vanquish the sole competitive threat in instant
photography. But Polaroid was unable to capitalize on the $925 million
judgment, and struggled to broaden its product line amidst the proliferation
of inexpensive 35mm cameras, one-hour photo kiosks and digital photography.
Eventually Polaroid filed for bankruptcy in 2001.
The moral of these stories is that success today does not ensure survival
tomorrow; therefore, investors need to diversify so that these kinds of
events will not destroy their portfolio.
In the book Creative Destruction, McKinsey & Company consultants Richard
Foster and Sarah Kaplan researched the original S&P 500, which was
created in 1957. The survival of companies is similar to the survival
of mutual fund managers. Figure 3-1 shows that in the
41 years from 1957 to 1998, only 74 of the original 500 companies were
still in existence and only 12 of those outperformed the S&P 500 Index
over the 1957 to 1998 period. The study found that the odds of picking
a winning stock that beat the S&P 500 Index was one in 42.
Most investors
operate under the misguided assumption that great companies are excellent investments. They believe that these companies
can defy the poor odds of beating the market. In fact,
almost the entire investment industry thrives on recommending a handful of “great stocks
to buy now." The firms represented in Figure 3-1a are widely
considered to be industry leaders. They have been included at some
point among the top ten "Most Admired Companies" in Fortune's
annual survey.
The
figure depicts
the results of an IFA study which sets forth the total return comparisons
for the S&P 500 index, IFA Index Portfolios and those of highly regarded companies. October 1, 2002 was chosen as a starting point because it was near the lowest point of the S&P 500 over the last 10 years. As you
can see, not one of the admired companies came close to
the total return of 104% for the S&P
500 Index in the 5-year time period from October 1, 2002 through
September 30, 2007. The closest was Berkshire Hathaway, with a 59% return. The company's CEO, Warren Buffett, was named the World's Number One Billionaire for 2007, with a fortune valued at $62 Billion. The time proved to be even more profitable
for the IFA Index Portfolios (IP).
The small value heavily tilted all-equity IP 100 had a total return of 184%, while
the all-equity IP 90 gained 172%. IP 80, with 10% fixed income
to dampen volatility, gained 150%, while IP 70, with 20% fixed
income gained 130%. IP 60 had 30% fixed income and still returned
112%. Even more interesting, the Emerging Market Value Index, that has had about the same risk (standard deviation) as Berkshire Hathaway over a recent twenty year period, had a total return of 586% (not shown in the chart below). Index investors enjoyed a wonderful increase
in their portfolios, while investors of these admired stocks
missed out on an enormous profit opportunity.
Figure
3-1a
In Figure
3-1b, you can see the risk and return of the 30 Dow Jones Industrial
stocks, which include several of the stocks listed above, but over a 20-year period. Please note that for the risk taken, not one company exceeded
the return that would be expected based on the diagonal line that estimates
the appropriate return for the risk taken. This line is known as the Capital
Markets Line.
Figure 3-1b
In the February 19, 2001 issue, Fortune Magazine published its list of the Ten Most Admired Companies in America. It is a pretty good bet that many Americans purchased shares of those great companies hoping to earn above market returns over the next 10 years. How did that work out?
Figure 3-1c
Further research
demonstrating that good companies make bad investments is found in
a 1987 study titled, “In Search of Excellence: The
Investor’s Viewpoint.” In the study, investment analyst Michelle
Clayman compared the returns of 29 “excellent companies” with
39 “unexcellent companies.” Clayman’s idea
for this study originated from the 1982 best-seller In Search
of Excellence by Tom Peters and Bob Waterman, which described
43 successful U.S. companies of which 36 were publicly traded.
The book awarded companies an “excellent status” by
virtue of their profitability, employee satisfaction and overall
good working conditions, inspiring stock pickers nationwide to
believe that they too could use winning companies to make winning
investments. Clayman compared 29 of Peters' and Waterman’s “innovative
and excellent” companies with 39 “unexcellent” companies
she selected. Her criteria for unexcellent companies included
those with terrible profitability and “Dark Ages” management.
Examples of her excellent companies included powerhouses such
as Johnson and Johnson, Intel, Merck, and Disney. Unexcellent
companies were made up of companies like U.S. Steel, American
Motors, Westinghouse Electric, and F.W. Woolworth.
Figure 3-1c shows
that Clayman's excellent companies were stronger by every economic measure
than her unexcellent ones for the five-year period between 1981 through
1985. “The excellent companies have qualities we would all love
to see in our own companies,” she observed.
Figure 3-1c
Clayman found, however,
that the unexcellent companies showed significantly greater returns over
the five years than their healthier counterparts. Figure 3-1d illustrates that between 1981 and 1985, the unexcellent companies earned
investors a 298% total return while the excellent companies earned only
a 182% total return. The two portfolios had almost identical standard
deviations, so what made the unexcellent portfolio deliver such higher
returns to its investors? The discrepancy arises because the higher cost
of capital for unexcellent companies is paid to investors. Similar to
individuals who approach banks for loans, borrowers with strong credit
and payment histories will receive loans with lower interest rates (lower
costs of capital) than that of a riskier borrower. Less stable companies
end up paying higher costs of capital in exchange for their higher risk,
which translates to a lower stock price relative to book value and a higher
expected return for investors in those risky companies.
Remember Peter Lynch’s advice about buying companies whose products you like? It turns out this advice is not as good as it sounds. Great companies don’t make great investments. You may love Apple’s iPad, but this doesn’t mean Apple is a great stock to buy. In fact, the opposite is usually true. Distressed companies have earned higher returns than those of companies with lots of hype or goodwill. Unfortunately, investors generally avoid investing in distressed companies, because it seems counterintuitive to buy perceived losers.
Finance Professors Meir Statman and Deniz Anginer wrote a 2010 study called, “Stocks of Admired Companies and Spurned Ones.” Their study was based on Fortune Magazine’s annual list of “America’s Most Admired Companies” from 1983 to 2007. Fortune’s annual surveys ranked companies on eight attributes of reputation:
Quality of management
Quality of products or services
Innovativeness
Long-term investment value
Financial soundness
Ability to attract, develop, and keep talented people
Responsibility to the community and the environment
Wise use of company assets
From these ratings, Statman and Anginer constructed two portfolios, each consisting of one half of the Fortune stocks. The “admired” portfolio (often referred to as growth stocks) contained the stocks with the highest Fortune ratings, and the “spurned” portfolio (often referred to as value stocks) contained the stocks with the lowest Fortune ratings. For example, the list of admired companies included The Walt Disney Company, UPS, and Google. Spurned companies included Jet Blue, Bridgestone, and Stanley Works.
The results of the study are of no surprise to value investors. “Stocks of admired companies had lower returns, on average, than stocks of spurned companies.” The Figure below shows the 16.12% annualized return of the spurned portfolio and the 13.81% annualized return of the admired portfolio over the 24-year, 9-month period.
Figure-Admired vs Spurned
Why have value stocks delivered higher returns to their investors? The market perceives value companies to be riskier, driving down stock prices so their expected returns are high enough to attract investors. That is difficult for most investors to grasp since they prefer to believe growth stocks are better investments than value stocks. After all, investors looking for a stock tip want to hear the name of the next Apple, not the next JCPenney. As you will see in Step 8, the data indicates that investors should be interested in great investments (value stocks), not just great companies (growth stocks).
