3. Exploit Your Edge; Eliminate Your Weakness I—Beating the Street

Developing an investment process is not for the faint of heart. You have to be ruthless and level-headed when it comes to evaluating not just your portfolio but yourself and your own emotions. The first step toward surviving the jungle of the financial markets is to take a long hard look at yourself. Only then will you recognize the ways your own instincts—everything from your eagerness to believe that hard work is enough to basic human emotions such as greed, fear, pride, and an addiction to excitement—can undermine your ability to remain calm in the face of a noisy and chaotic market. Only then can you realistically evaluate your own abilities and limitations and learn to discern when and where you really possess an “edge” in the market.

Skeptical? Just think about the market meltdown of 2008, when emotions ran amok. Of course, there were plenty of cogent reasons for selling stocks that autumn. The credit markets were caught in a deep freeze, leaving otherwise sound companies without access to short-term capital to finance their operating costs. In the wake of the collapse of two investment banks and the overnight sale of Merrill Lynch & Co. to Bank of America, not even the savviest or most venerable investor could predict what might happen next, and risk aversion soared to unprecedented levels. That sent the stock market into a tailspin. Clearly, some of those sellers had to sell to meet margin calls or raise capital to stay in business. But along with this kind of “rational” selling came a kind of indiscriminate downward pressure that I can only call spectator selling: Panicking, individuals dumped everything they owned onto the market in hope of finding a buyer at any price. Emotions took over.

Whenever individual investors begin to chase the market, they lose. That will prove to be the case with the market meltdown of 2008, as many investors almost certainly will end up repurchasing securities they dumped at rock-bottom prices during the midst of the panic at much higher valuations once enough time has passed that we can all separate the truly troubled companies from those that happened to be in the wrong place at the wrong time (that is, traded on any global stock exchange in the second half of 2008). As individuals, what we imagine to be our “edge”—our conviction that we have a knack for picking stocks on our own that will outperform the market—is in fact a weakness. Even after 25 years in the trenches, I still get tempted by an exciting story about an individual stock. Hot stocks are dramatic. When you win with one, it’s as if you had won the lottery, but even better because you can lay claim to insight and judgment rather than just dumb luck. But hot stocks are elusive, and their pursuit is much more likely to cost you money than earn you rich returns.

Your edge lies, ironically, in your willingness to acknowledge that as an individual investor you’re at a big disadvantage when it comes to unearthing not only the stock market’s buried gems but even the most straightforward and solid investment strategy. For individual investors, picking stocks is an uphill battle. Even the pros can have challenges. For example, Bill Miller, managing the Legg Mason Value Trust since 1992, beat the S&P 500 for 15 years running before failing to do so again in 2006. (Miller’s closest rivals in 2006, each with a 7-year winning streak, were two obscure funds with offbeat and risky investment strategies.) Firms like Legg Mason continue devoting millions of dollars in resources each year to trying to beat a market index, and they have the ability to do that. Boston-based Fidelity Investments, for instance, now handles $1 trillion in assets, and can well afford to pay six-digit salaries to each of their 180 or so in-house research analysts in the hope that each of them will find at least one brilliant idea amid the thousands of global businesses whose financial statements and filings they peruse 60 hours or more each week. Across the industry as a whole, there are now about 91,000 money managers and investment analysts who have survived many years of study and three rigorous examinations to win the title of Chartered Financial Analyst. Thousands more are working toward that certification, or working without it. Many are being well paid to do nothing but work away to find the next stock market winner.

When you decide to build an investment process as an individual investor that revolves around stock picking, you’re going up against all those bright minds and all those resources. That’s why investors value quality research. You may yearn to find the brilliant idea that somehow escapes this vast net cast by the investment industry; the odds, however, say that you won’t. Yes, in the Internet era, any investor has access to most of the documents and reports they need to identify a company that is struggling under too much debt or one whose new product is poised to become a bestseller. The goal of Regulation FD, a rule imposed by the Securities & Exchange Commission that requires a company to disclose material facts, was to remove institutional advantages that the pros possess. No longer can the CEO of a manufacturing company legally provide extra insight into a new contract to institutional money managers without providing that disclosure at the same time to the rest of the world. But there are some built-in advantages that no regulatory edict can remove. For instance, you’re not going to quit your day job to study financial statements in hopes of passing the CFA examinations, are you? Just as an investment analyst can’t repair a heart valve, a cardiac surgeon doesn’t have the specialized knowledge that the pros accumulate doing their job one day after the next, year after year.

Just how large is the advantage that the pros enjoy when it comes to picking stocks? Well, they have Bloomberg terminals sitting on their desks that, at a cost of anywhere from $17,000 to $21,000 a year, deliver everything from the basic stock quotes to news and complex analytical models. They are great, and I admit my job would be much more difficult without one on my desk. But let’s face it, if you’re trying to build wealth, spending this much annually isn’t the most rational thing you can do. And you need more than the Bloomberg: Your shopping list should include an annual subscription to Baseline or Factset to obtain other critical data (another $12,000 a year) and independent investment research from at least two different firms (about $20,000 each). So before you have made a single investment decision, you have accumulated perhaps $70,000 in annual expenses, all of which will need to be recouped through the investment ideas that they generate. And I haven’t even mentioned the cost of subscribing to a real-time data service or the expenses of going to industry conferences in person to get access to the same insights the Fidelity team can obtain with a phone call. Daunted yet? Then let’s also factor in the cost of human capital—all those skilled traders that firms like Fidelity hire to be sure the “buy” and “sell” ideas are executed at just the right price, or the technology geeks who makes sure your computer runs properly. Hedge funds go still further, hiring industry experts to offer their insights into whatever industry is attracting the fund manager’s attention in the same way a lawyer might hire an expert witness to defend a murderer on trial.

To you or me—as individuals—the financial cost of becoming a well-informed stock picker is prohibitively high. To the average institution, however, it’s far easier—the price of entry into the business. And there are more intangible benefits that come from being part of an organization devoted to hunting for great investment ideas. For instance, an investor working for Goldman Sachs can pick up the phone at any time of the day to talk to traders in Hong Kong or London about what is happening to a stock there, or to obtain insight from a local analyst about the potential demand for iPods in the Chinese market. Sometimes it’s that extra smidgen of data or piece of insight that leads to the best investment ideas—and individual investors don’t have easy access to that network.

Being part of that network brings other benefits. Insider trading may be illegal (although it certainly still takes place), but not all cases of privileged access to corporate information come under the heading of insider trading. If you happen to meet a CEO of a company and have extensive discussions with him or her, one on one, you may well decide that this is a particularly canny individual who will transform the company into a top performer. If you aren’t a member of the investment world, or part of that CEO’s personal network, however, what are the odds that you’ll be able to have that chat in the first place? Remember that although investors in Internet and Biotech IPO shares at the time of their initial public offering fared very well indeed, the serious money was generally made by those company’s earliest backers. These include venture capitalists, but also other members of their extended circles, all of whom invested privately in the company while it was still a tiny start-up. Investors in many of those IPOs fared pretty well. However, the original insiders generally fared much better.

Then there are the junkets, the trips organized by companies for professional investors, in hopes of persuading them to buy shares. I don’t often venture out on this kind of expedition, but I was curious enough about the Canadian oil sands—described by Time magazine as “Canada’s greatest buried energy treasure,” oil reserves that may be second only to those of Saudi Arabia and which some argue may be able to meet the world’s insatiable hunger for petroleum products for the remainder of the twenty-first century—to venture to northern Alberta on a trip organized by Shell Canada. Along with two dozen analysts and portfolio managers, I hopped aboard an elderly retired turbo-prop commuter plane in Calgary for the hour-long flight to North America’s latest boomtown, Fort McMurray. Rattling along its bumpy and still unpaved roads in the yellow school bus sent to the airstrip’s Quonset hut to transport us to Shell Canada’s Albian Sands operation, we felt woefully out of place in our sports jackets and neatly pressed khaki pants as we drove past hastily constructed concrete block apartment buildings and bars. The trip accomplished what it was supposed to, however: Without exception, our jaws dropped in awe at the scale of the operation. Enormous dump-truck-like vehicles, with tires measuring a whopping 12 feet in diameter, transport massive amounts of sand excavated from the ground to the silos where the process of stripping the increasingly valuable “heavy oil” from the sand itself begins, with two tons of oily sand required to produce a single barrel of oil.

Investment analysts exist to help the rest of the market sort through the universe of investment opportunities and help us understand whether or not an oil sands ‘play’ is, indeed, a good addition to a portfolio. But even if you and I had access to all the research reports cranked out each year, would we end up making better investment decisions? Not necessarily. Even if we could winnow our way through the forest and focus on one or two trees, the odds are still that we, as individual investors, would be late to the party. Another edge for the pros is their ability to build a diversified portfolio rapidly; your ability to match them or beat them is remote. Individuals who have recognized their disadvantage have hired financial advisors to invest on their behalf.

Let’s say that every time you visit Bed Bath & Beyond to replace your vacuum cleaner, or to buy a new coffee grinder or bath towels, you have been impressed how many fellow shoppers are making big purchases. The company’s financial statements confirm that your firsthand impressions were on the money. And—the last item on your checklist—the analyst reports you have read from Smith Barney and ValueLine all say the stock is screaming “buy” at its current valuations. Whoa! Stop, take a deep breath. Remember that Bed Bath & Beyond’s stock already reflects the collective decisions of many of those professional analysts and investment managers. When it comes to Bed Bath & Beyond, two dozen or so analysts from different firms follow the company’s stock for their institutional clients. It’s likely that those analysts and money managers from firms like Fidelity, American Funds, and scores of smaller management firms have already worn a path in the carpet leading to the offices of Steven Temares, the company’s CEO, as well as those of his top lieutenants. They’re doing what you do—shopping at the local outlet—but also hopping on planes to check out the latest branch and ferreting out whether a particular high-margin profit line is doing as well as the CEO promised last quarter. Oh yes, and they are reading publications such as Home Access Today, Home Furniture News, and Bedding and Specialty Bedroom to be sure they are on top of the emerging trends that might affect the company, its suppliers, and its rivals.

Still feel as confident that you have a unique insight into the company’s prospects? Even if you do, building a portfolio with a single specialty retailing stock would be too risky. You have to repeat the process for at least 19 other companies, in different industries, whose businesses will depend on a completely different set of variables. That means not only keeping pace with all the specialty retailing analysts, but all the technology analysts (if you decide to buy Dell), all the energy analysts, if you’re as intrigued by the oil sands project as I was, and so on. Meanwhile, Goldman Sachs doesn’t ask its retailing analyst to hop on the plane to Fort McMurray and become an instant expert on oil sands technology, or send its semiconductor analyst off to scrutinize and render a verdict on the latest breakthrough at a genetic research firm. Figure 3.1 shows the amount of risk reduction an investor enjoys by building individual stocks into sectors, and the S&P 500 as a whole.

Figure 3.1 Risk reduction achieved by diversification within the S&P 500 Index.

Source: Harris Private Bank, Innovative Solutions Team Annualized Risk Since 1989

Almost the only possible “edge” individual investors possess when it comes to identifying a great stock or investment idea ahead of the pros is inside knowledge of a particular business or industry, probably acquired because you have worked inside it and know all the players and issues firsthand. If you are honest with yourself about the extent and depth of that knowledge, and employ it sensibly, you might just be able to beat the index. Let’s say you have just retired after spending the past 30 years in a series of progressively responsible executive positions in the insurance industry, moving from property and casualty firms to one of the giant life insurers. You know the factors that spell the difference between success and failure for an insurance company in those businesses and can pick up subtle signals that less-savvy investors might miss. The trick on how to profit from this expertise is to combine active stock picking in the sector where you do have an edge with more passive investing in other market sectors, from technology to health care to retailing. Go ahead, overweight Chubb—just don’t succumb to the temptation to think that makes you an expert about Bed Bath & Beyond’s prospects.

There are two ways to exploit this particular edge. Both require you to be able to compile a list of stocks in your industry that you expect to be winners, along with another that you believe will be laggards. The purest way for a retired insurance executive to transform his or her knowledge into stock-market-beating profits is to buy the “forecast winners” stocks while simultaneously selling short the “forecast losers.” (Short selling means borrowing the stock and selling it in the expectation of being able to repurchase and replace that borrowed stock at a lower price later on, the profit being the difference between the two prices. It’s a risky strategy, because the loss can theoretically be infinite.) As long as you get it right (and don’t underestimate how difficult that is) and the returns from your expected winners materialize while your forecast losers stumble, you should be able to book profits on your portfolio regardless of what the rest of the market is doing. In a bull market environment, if the winners return an average of 15% and the “losers” manage to eke out a 5% return, you may end up losing money on your short positions, but you’re still ahead 10%. In a bear market, as long as the losers decline by more than the “forecast winners” do, you’ll still emerge with a net profit on these positions. To ensure that you outpace the S&P 500, all you need to do is take that net profit from those trades and invest it in an S&P 500 futures contract, which promises its owner the return on that index as well as any appreciation in the value of the futures contract itself.

An alternative strategy for investors who aren’t comfortable with the degree of risk involved in selling short is to take an index-like position in all the stocks and sectors in the S&P 500, identical in weighting to those in the index—with the exception of the insurance industry. You then take the 4.3% index exposure to insurance in the S&P 500 and invest that money actively, picking only those stocks that you believe will outperform and overweighting them. Again, as long as you get the winners right, you’ll beat the S&P.

The biggest problem with this strategy is that investors usually don’t have that level of expertise or insight into any given industry. Three decades as a successful cardiac surgeon might give anyone insight into how well certain medical devices perform in practice, but not into the many other factors that determine what makes one next-generation cardiac monitoring system a success and another a failure. Most investors who opt to use stock picking as the basis of their investment process will, at some point, have to rely on investment research to help build a diversified portfolio. Much of this is generated by the same folks I mentioned earlier, those devoted full time to their analytical work and with access to all the resources a big investment firm can offer. Why not tap into their collective wisdom? If you can’t beat them, why not join them, by signing on the dotted line and becoming a client of one (say, Morgan Stanley)?

The research community has had its share of challenges, although most of them have been removed in recent years after the scandal in which Citigroup’s star telecommunications analyst, Jack Grubman, was shown to have compromised his objectivity. In what proved to be just the most blatant of many such deals across Wall Street, Grubman agreed to put a buy rating on AT&T stock—a rating his CEO, Sandy Weill, wanted to have to win underwriting business from AT&T—in exchange for a big donation by Weill to a Manhattan preschool in which Grubman was trying to enroll his twin toddlers. Ultimately, in April 2003, ten of the largest Wall Street firms agreed to pay $1.4 billion in fines for having published biased research, as part of a pact settling pending regulatory investigations by the Securities and Exchange Commission.

In addition to using quality research, what about entrusting your money to a successful money manager, and count on him or her to pick the right stocks? At any given time, there are plenty of successful money managers in the market. There also, however, “hot hands” in the market: money managers who achieve eye-popping investment returns during a period in which their area of expertise and talents coincide exactly with what is required to identify that handful of stocks that the market will reward in the coming year or so. But inevitably, their moment in the sun will pass. Think of all the Internet and dot.com stock pickers lauded in the pages of the financial press in 1999. Where are they now? Alberto Vilar ran afoul of regulators and wound up convicted of fraud for looting his clients’ accounts to finance his philanthropic donations after the dot.com bubble burst in 2000 and left him strapped for cash. In 1998, Ryan Jacob, then 29 years old, posted returns of 196% and opened his own Internet fund the following year. The new fund quickly lost 95% of its assets as the dot.com bubble burst, and Jacob has battled to boost its size back above $100 million—well below the $500 million plus he had to play with at its peak.

No one has managed to demonstrate scientifically what skills are required to outperform the market, but Thomas McGuigan, president of Beyond Tomorrow Strategic Advisors LLC in Guilford, Connecticut, has proven how difficult it is to accomplish that feat. In a 2006 study, he and his team took the performance of all mutual funds investing in large-capitalization U.S. stocks over the 20-year period ending November 30, 2003. A mere 10.59% of those funds beat the S&P 500 in that time period, but over rolling 10-year periods, 24.71% of the funds outperformed the index. Intrigued, McGuigan delved more deeply into the results. The result? For every manager who could claim to have outperformed the index, more than one lagged; while 2 funds outperformed the S&P 500 over the 20-year study period by between 1 and 2 percentage points, 37 trailed by the same amount. McGuigan’s next question was whether historic performance said anything about a fund manager’s ability to outperform in the future. Alas, managers who outperformed in the first decade lagged in the second 10-year period. Only 28.5% of top-quintile performers hung on to their position in that elite group in the second decade, regardless of whether they were investing in large- or small-cap stocks.

So what is an investor’s edge in this kind of Darwinian struggle? A significant part of it lies in the investor acknowledging that he or she is at a disadvantage when it comes to trying to pick the best-performing stocks. Why compete with the professional investors head to head on what remains anything but a level playing field? As an independent investor, your “added edge” can be your ability to pick markets. “Are stocks the right asset class to be in at this time?” is one key question to ask, not “what stock is going to make my fortune?” Instead of only asking which technology fund manager has the top track record, the better strategy is to also look at the bigger picture. “Are small stocks or large-cap stocks more attractive in this environment?”

These questions are ones you are more likely to be able to answer and are more likely to lead to sensible investment decisions. Paradoxically, they are also the questions too often ignored or overlooked by inferior money managers who struggle to generate sustained periods of outperformance. You as an individual investor have the relative luxury of being able to put your investment capital wherever you want—wherever the returns seem most appealing or the risk seems to be lowest. That is part of your edge, made even more compelling by the fact that often the well-paid teams of professionals don’t have the same flexibility. Pension funds and other institutions that choose professionals to manage their assets don’t typically favor picking those who adopt a global macro approach. Most asset-allocation decisions have already been made by the investment consultants that pension fund and endowment trustees retain. The consultant who wins a mandate to advise a pension fund, college endowment, or other big pool of capital starts off by analyzing the risk profile and liquidity needs of that fund, based on a survey of its assets and obligations, and then prescribes a target allocation to various markets (stocks, bonds, real estate, commodities, hedge funds, and so on) that matches those liquidity needs and the fund’s overall risk profile. For each designated market, the consultant goes on to pick, from a short list, the manager it believes will do best at delivering a portfolio that will fare better than its peers. Let’s say that both you and that consultant invest in the same small-cap stock fund. You have different goals in mind. The consultant wants the fund to beat its index and its peers, you want it to make money. The two don’t always go hand in hand. Small-cap stocks can be out of favor, and if you’ve backed a relative outperformer, you’re still going to be losing money, while the consultant is reconciled to that, because his client’s needs are different.

Traditionally, consultants’ methodology shuns tactical asset allocation; the process of rebalancing assets on an ongoing basis in response to what is happening within the financial markets, reacting to new opportunities and the emergence of new risks. That is just what you, as an individual investor, need: an investment process that depends on a rigorous and constantly updated analysis of what is happening within the stock or bond market. A large-cap money manager is going to have large-cap stocks—with their distinctive characteristics—in his or her portfolio at all times, regardless of how attractive they are relative to small-cap stocks or emerging markets bonds. That manager doesn’t have a choice, but you do. And that is your edge.

So why do so many investors continue to overlook their edge and instead emphasize their weakness by competing with the resource-heavy pros to try to select only individual stocks? Tens of thousands of individuals subscribe to stock-picking newsletters; hundreds of thousands to monthly magazines that each and every month promise to give them the names of, say, the top seven recession-proof stocks or the best “green” energy stock plays. And millions still tune in daily to Jim Cramer’s show on CNBC. The harsh truth? Even once we acknowledge the many institutional challenges of stock picking, before we can add a more rational global macro investment process we still must be prepared to battle another of our biggest weaknesses: human nature.