Tuesday, November 30, 2010

Stock picking doesn't work, they say...

The standard investment advice these days is that one should invest in index funds rather than picking individual stocks or investing in mutual funds that have managers that actively picked stocks. And if everyone did that? Individual stocks would be mispriced.

Suppose currently, FOOD is 20% of the index, WDGT is 30%, and POOP is 50%. Suppose all are valued at the same 15 P/E. If everyone invests via index funds, everyone will be 20% in FOOD, 30% in WDGT, and 50% in POOP.

Now suppose Foodies, Inc. has a fine management team in a growth industry. Their earnings double. At the same time, PoopCo is having problems due to mismanagement. Their product development pipeline is, shall we say, constipated. As a result, their earnings halve.

Thus, at this point, FOOD has a P/E of 7.5, and POOP has a P/E of 30. The right thing would be for FOOD to double in value, and for POOP to lose half its value. If everyone is investing via an index, the supply and demand for FOOD and POOP remain pegged to the initial 20% and 50% allocations. The supply and demand are completely divorced from any per-stock evaluation of worth. There is no longer any mechanism for rebalancing, and the market no longer reflects fair value. It becomes even worse when you factor in money entering and leaving the market.

That is, unless there are a few investors who disobey this advice. Those guys would make a killing. How? There are two ways. As just plain old stock investors, they would keep buying FOOD and shorting POOP until their prices reached their fair value. Everyone investing via indexes would have to keep rebalancing their portfolios to keep up, and they'd be paying all the way up (or down). Alternately, if they were big, they could just take the companies private. If you had the cash, you'd jump at the chance to buy a company at 5x earnings (all else being equal and sane) just to capture that cash flow.

The standard advice, then, only works if some people don't follow it. Otherwise, the market remains static. At any given point in time, about half of stocks will be undervalued, and half of stocks will be overvalued. In the best scenario, the overall market capitalization reflects the total fair value of all stocks, but nearly every single stock will be badly priced.

Bonus questions:

  • How does a passively-managed market value IPOs?

  • What would happen if all undervalued companies were taken private for a time, then flipped back on the open market?

  • What happens to automated trading strategies that do not rely on fundamentals

  • If you're an active stock trader, either for yourself or to manage a fund, wouldn't you want everyone else in the market to be investing passively? Is that why we keep hearing this advice?



Blogger Rich said...

Stock picking requires a lot of time, research, and experience to get right. The conventional wisdom is for the 99% of us that don't have all three of those.

And if even if you, the market is beyond rational. There are so many factors that go into the pricing of a stock that if it were simply fundamentals we'd have a perfect market already.

A successful wall street trader (forgot his name) said on Planet Money that the only two ways to make above market money trading was luck and cheating (insider trading). Without the resources or lack or scruples to do the later, you're putting your fate in the strange creature that is luck.

I'll end with evidence. If this strategy were doable, why are there no funds that consistently beat the market by a large margin?

April 7, 2014 at 11:51 AM  

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